With Tax Deal in Sight, it’s Time for Year-End Planning

On Monday evening, President Obama announced the outlines of the deal that had been reached between Republicans, who wanted to see the Bush tax cuts extended for all taxpayers-- including the wealthiest--and Democrats, who wanted those tax breaks to expire for couples who make more than $250,000 a year and singles who earn over $200,000 a year.

The agreement taking shape would keep the Bush tax cuts in place for all taxpayers for two years, bringing the discussion back in time for the next Presidential election; extend unemployment insurance for 13 months; cut payroll taxes for all workers for one year; extend a slew of tax credits for middle-class Americans; and reinstate the estate tax at a higher exemption and a lower rate.

“Make no mistake: Allowing taxes to go up on all Americans would have raised taxes by $3,000 for a typical American family. And that could cost our economy well over a million jobs,” Obama said in announcing the compromise. The package would cost about $900 billion over the next two years.

Whether you agree or disagree with the compromise --and there are things in it for both Republicans and Democrats to love and to hate--the nearing resolution means that if you’ve been putting off year-end tax planning because of the flux in Washington, you can now get down to business.

“The bottom line is that everybody has to put brakes on all their thinking and change their mindset, and there’s not much time,” says Andrew Katzenstein, a partner in Proskauer’s personal planning department in Los Angeles. With just over three weeks to go in 2010, here are three key things to think about:

Timing of deductions and income. For those who thought their tax rates were going to go up, it was simple math: Deductions for expenses are worth more when taxes are higher, so the smart thinking was to defer some of them till after January 1st. Similarly, it would have made sense to accelerate income, when possible, into 2010, if rates were going to go up.

The tax deal overturns that thinking: It’s fine to take your deductions now. For example, you can pay state income taxes and real estate taxes before year end, and make your charitable deductions before the year is up, as you normally would. And it no longer makes sense for high-income taxpayers to accelerate income, pushing bonuses or other payouts into the current year.

What you were planning to do before the agreement took shape, “do the opposite,” says Katzenstein. “Where you were going to hold off on deductions, now you can take them. And if you were thinking about waiting till next year to make gifts to charity, now you can make them this year.”

Investments. When it appeared that tax rates on long-term capital gains might go up from 15% to 20%, the common wisdom was to look at selling now to lock in that lower rate. With the Bush tax cuts extended for all, there’s no longer any need to do that--unless you want to for investment purposes. If you don’t yet have capital losses stockpiled (as so many people already do), it is still worth taking them. Tax rules allow you to offset capital gains with capital losses, and then to deduct $3,000 against income each year. If you have more capital losses than you can use up in one year, you can carry them over to offset future years’ income.

Estate planning. The agreement shaping up would let the estate tax come back next year, but with a $5 million exemption and a 35% rate. That higher exemption--versus the $3.5 million level Democrats wanted and the $1 million the estate tax would be in 2011 without action--means that fewer people will be subject to the estate tax. For those who still will need to think about estate planning, it’s time to get your estate attorney on the phone, as there are many outstanding complications to sort through. Between now and yearend, one of the simplest things to do is to give money away.

The rules permit anyone to give away up to $13,000 per beneficiary tax-free this year. Beyond that, there are extra advantages to gifting while you’re alive: Even when the gift and estate taxes are at the same rate, gifting (which has a $1 million lifetime limit) is a better deal. That’s because the government tallies the bill exclusive of tax for gifts versus inclusive of it for estates.