There are only a few weeks left this year and, as with every year, the year-end represents the last chance to take advantage of various opportunities in our financial world. Our previous article, "When Losses are a Good Thing" discussed a specific strategy which hasn't really changed much in many years - tax-loss harvesting. This article will be less in-depth but cover a wider variety of issues, many of which are very specific to this year-end, 2010. Note that several of these issues reflect current tax law, including the impending expiration of various provisions of the 2001 and 2003 tax reforms (often referred to as the "Bush Tax Cuts"). If Congress and the President can manage to come to terms, some of these deadlines will not be as important (for example, long-term capital gains tax rates and qualified dividend income tax rates are both scheduled to go up significantly after the new year. The President wants to keep the current rates for most folks, the Republicans in Congress generally want to keep the current rates on those things for everyone. If they can't come to any agreement, these rates will go up for almost everyone.)
• Realize capital gains and losses - every year
As mentioned earlier, every capital loss in your taxable portfolio represents an opportunity to cut your taxes, either by offsetting capital gains you may be realizing (whether you intended to or not - if you hold mutual funds, you may be getting capital gains distributions even if you didn't actually sell anything yourself), or (and perhaps better) if you've already offset any capital gains, providing you a valuable deduction against ordinary income. So if you are holding any securities or funds with substantial capital losses in your taxable portfolio, consider realizing those losses. If you want to maintain your exposure to the asset class represented by that security, you either may buy a similar security (such as a different mutual fund which has a similar style - just make sure the security you buy is not "substantially identical") or you may wait 31 days to buy back that security or the "substantially identical" one you had your eye on anyway. Fairmark has a great tutorial on the wash sale rules.
• Make taxable gifts - a 2010 special situation
Even though the Estate Tax was repealed for 2010 (see several of our earlier articles about it), it's worth remembering that (a) it comes back in 2011 and at a very punishing level; and (b) gift taxes were not eliminated for 2010. However, the gift tax rate was brought down to 35% for 2010. Moreover, the Generation Skipping Tax was also repealed in 2010 and will come back in 2011. This means that if you plan on making taxable gifts to anyone (ie. any gifts above the annual exclusion of $13,000), you will start using up your lifetime gift tax exclusion. If you've already used it up, you may want to make sure to make additional gifts before year-end, so those gifts are taxed at the very much preferable 2010 rates instead of the much more punishing rates for 2011 (and doubly-taxed if they trigger the generation skipping rules). If you have any chance of running into these issues - ie. if you've given or plan on giving away more than a million dollars - consult your attorney and accountant NOW.
• Make tax-free gifts - every year
Aside from the issues of estate, gift and generation-skipping taxes mentioned above, one thing to remember is that every person, every year, is permitted to give a gift of up to $13,000 (2010, 2011) to any other individual tax-free. If the gift is an appreciated asset, the recipient may end up keeping the giver's cost basis (which may be useful if the recipient has a substantially lower income than the giver). Regardless, this annual gift tax exclusion is limited - currently $13,000/year per recipient - and each year that goes by without taking maximum advantage of it is a potentially valuable lost opportunity, particularly if one has enough assets that the estate tax may be an issue. For 2010, of course, there is no estate tax, but it comes back with a vengeance in 2011 and even if the government "fixes" this by setting a more reasonable level, there is almost no chance that the estate tax is permanently dead. That being the case, if you expect there's any chance your estate will be hit by the estate tax, it's best to get assets out of your estate as you can. The annual exclusion is a great opportunity to do so. If you don't want to give assets directly to a recipient for whatever reason (ie. a minor child, a person who is not capable of managing the assets, a disabled or special-needs person who may have government benefits in peril if they get assets), there are various tools one may use to utilize the annual gift tax exclusion while still maintaining some level of control over the assets in question. Unfortunately, some of the tools in question are somewhat complex and we strongly recommend consulting with an attorney if the situation warrants such things as trusts. If the recipient is, for example, your adult child and you fully trust that person to responsibly manage the asset, it may well be easiest to simply give him or her a check. But remember - every year that goes by that you don't give a gift is a year's worth of opportunity lost.
Remember, too, that contributions to a 529 plan are part of this. Consider making gifts to a 529 on behalf of your child. And if you've already given away the maximum to a particular person, keep that in mind if you were considering making a 529 contribution on that person's behalf as well. 529 plans are an easy way to get assets out of your estate while keeping them earmarked for a specific purpose and maintaining some level of control over those assets.
• Max out your 401(k) (or 403(b) or 457 plan) - every year
If your employer offers you a 401(k), and you haven't maxed it out, you may only have a couple of paychecks left from which you may have payroll deductions taken. The maximum elective deferral for 2010 is $16,500 (with a possible "catch-up" contribution of an additional $5,500 for folks who will have turned 50 before year-end). If you haven't maxed out the plan but can afford to, you may be letting a golden opportunity go by. Of course, we almost always strongly recommend for folks to contribute at least enough to get their full employer-match if there is one, but even if there isn't, there's still only a limited number of opportunities that one gets to save either tax-deferred (pre-tax contributions) or tax-free (after-tax "Roth" contributions). Every year that goes by that you don't maximize your use of those opportunities is lost forever.
• Start up a 401(k) (particularly a "solo 401(k)" for the self-employed) - every year
Ever since the solo-401(k) came into existence just a few years ago, it's represented one of the best opportunities for self-employed individuals to be able to save for their retirements. Until recently, managing a qualified defined contribution plan such as a 401(k) was not really cost-effective for the self-employed, but that changed a few years ago with the introduction of the "solo 401(k)". The solo 401(k) was created by the 2001 tax law, but unlike the so-called "Bush Tax Cuts" the solo 401(k) won't go away at the end of this year. A solo 401(k) allows a self-employed individual to put away as much as $16,500 in either pre-tax or after-tax ("Roth") contributions -- plus put in an "employer" contribution of up to 25% of compensation so long as the total combined amount saved on behalf of any individual is no more than $49,000. (excluding the possible additional $5,500 "catch-up" for folks over 50). That means a potentially massive amount of tax-free or tax-deferred savings. You don't have to fully fund your solo 401(k) by the end of the year - like any self-employed person, you may not know how much you actually made until you file your taxes for the year - but if you want to fund a solo 401(k) for 2010, you have to at least open the accounts before year-end.
If you don't open that solo 401(k) account by year end, don't fret. You can still open and fund a SEP-IRA as late as when you file your taxes for 2010. But for some folks, the solo 401(k) would allow them to save a lot more money. So if you think there's any chance you're going to want to establish and fund one for 2010, consider opening that account right now.
• Do a Roth conversion - special treatment for 2010, but still useful every year
Consider the Roth conversion. If you have money in an IRA (or, since Sept 2010 due to the Small Business Jobs Act of 2010, in an employer-sponsored 401(k) which has Roth provisions), you may be eligible to convert your pre-tax contributions into after-tax "Roth" contributions. If you do perform such a conversion, the converted savings will grow tax-free in the future. When you eventually take distributions from such "Roth" assets, the distributions will be tax-free. Moreover, unlike regular pre-tax 401(k) or IRA savings, these Roth assets will not be subject to required minimum distribution rules. You may allow those savings to keep growing well into your retirement if you don't need them to live off of. Since the beginning of 2010, the income threshold went away - before 2010, you were only permitted to perform a Roth conversion if your income was low enough. Now, anyone may make such a conversion regardless of income (if otherwise qualified). So every year, as we approach year-end, it's time to take a last look at one's pre-tax assets and consider if or how much of those assets should be converted to Roth accounts. Note two things: one - conversions may be undone. See our recent article "Taking a Mulligan on a Roth IRA Conversion" for more details. And two - if you do convert assets from pre-tax accounts to Roth accounts, you will (most likely) owe income taxes on the amount converted. Do not perform such a conversion if you don't have the money available with which to pay those taxes. You almost certainly do not want to pay those taxes out of money in the IRA account in question since you'd have to take a taxable (and potentially subject to a penalty!) distribution in order to pay the taxes. For more about the tax consequences of Roth conversions, see "Can I put money into a Roth IRA".
One more thing about Roth conversions, specifically regarding 2010. Only in 2010, if one does a Roth conversion, one has an option to either include the taxable portion of the conversion entirely in one's 2010 income -- or spread it out over two years and include 50% of the taxable portion of the conversion in 2011 and 50% in 2012 income. This is a potentially valuable opportunity if you know either that your income in 2010 is especially low - or you know that your income is going to be lower in 2011 and/or 2012. Moreover, you do not have to decide which way you are going - all in 2010 or half each in 2011 and 2012 - until you file your 2010 taxes. And remember, you can undo a conversion up until you file your taxes, so if you're considering doing it, there's good incentive to make the conversion even if you're not certain.
• Make more gifts - to charity - every year
Year-end is when all the charities remember to ask you for donations. Many of them are potentially deductible on your income taxes. If you're going to write a check or make a contribution by credit card, do so now. However, you may have an even better opportunity. If you have appreciated assets such as stock or mutual funds shares in a taxable account, you may be able to not only get a tax deduction for the value of the contribution but also avoid ever paying capital gains taxes on that appreciation. Most charities are happy to discuss the chance for you to give appreciated assets directly to them, but for convenience, it may be worth considering opening up an account at a donor-advised fund. Such a fund will allow you to make a single contribution and generally do so very easily (perhaps without even leaving your brokerage's website!), provide you with appropriate tax documentation, and make it easy to then have the fund send donations to a variety of charities of your choice. If you're going to give cash and haven't already established such a donor-advised fund account, it may be easiest to simply give cash directly. But if you have already established a donor-advised fund, or if your income is high this year but expected to go down, it may be worth bunching up your tax-deductible gifts by making a single gift to the fund and then taking your time distributing it to charities of your choice later on.
• Get some Energy-efficiency home-improvement tax credits - expiring at the end of 2010
There's a tax credit for 30% of the purchase costs up to $1,500 for certain energy efficiency improvements such as certain wood or pellet stoves, energy-efficient furnaces, water heaters, air-conditioning systems, insulated doors, windows and roofs. See the government's Energy Star website for details at http://www.energystar.gov/index.cfm?c=tax_credits.tx_index
Note that not all Energy Star qualified products qualify for the tax credit, and the improvements must be (a) installed before Dec. 31, 2010; and (b) must be to an existing home which is your principal residence.
• Buy a computer for a college student - 2010 specific
Only if the school requires them, one may buy a computer or laptop with Section 529 funds as a qualified expense. This expansion of the use of 529 funds was part of the American Recovery and Reinvestment Act of 2009 and applies to 2009 and 2010. For more details, see http://www.irs.gov/newsroom/article/0,,id=213034,00.html
In particular, the computer or equipment are to be used by the designated beneficiary of the 529 plan while enrolled at an eligible educational institution. Software designed for sports, games or hobbies does not qualify unless it is predominately educational in nature. A printer or other related peripheral equipment may qualify, but equipment primarily for amusement or entertainment does not. (It's not clear, for example, whether an iPad counts or not, though may schools are now distributing lectures as podcasts, so it's easily arguable that they should qualify).
• Buy some over-the-counter medication - 2010 specific
It's well-known that if you have a Flexible Spending Account through your employer, you need to spend it down before the end of the plan-year (sometimes year-end, sometimes April or June - it depends - check with your HR department). However, less well-known is the fact that the Patient Protection and Affordable Care Act ("ObamaCare") included a provision which will severely limit the use of FSA money. Starting with the new year, you may no longer use Flexible Spending Account, Health Reimbursement Account, or Health Savings Account (HSA) money on over-the-counter medications (except for insulin). You may still use your FSA or HSA money for prescription medications, prescription glasses, copayments and certain other costs. Most folks don't spend all that much through HSA and FSAs for over-the-counter stuff anyway - usually it's easier to get reimbursed for a few big purchases than for a bunch of little ones due to the documentation that one needs to submit. But for those folks who do plan on getting reimbursed for over-the-counter medications, it might be a good idea to stock up before year-end. Check expiration dates carefully.
• Take your Required Minimum Distribution from your IRA (or 401(k)) - every year
If you turned 70-1/2 this year, you've got a choice about your RMDs. If you are older than that (ie. turned 70-1/2 last year or before), you have less choice. Folks over 70-1/2 need to start taking their Required Minimum Distributions from IRAs and certain qualified plans (like 401(k) plans). The government allowed you to not have to pay taxes on money you put into those plans, and the money in them has grown (hopefully) and you haven't paid any taxes yet. But Uncle Sam wants his cut. Starting when you turn 70-1/2, you have to start taking distributions and paying taxes on money in these plans. The RMD or Required Minimum Distribution is based on your age (and thus life expectancy) and the value of your account at the end of the previous year. For 2010 RMDs, the numbers you'll need to calculate it are the balances of all your IRA accounts at the end of 2009 (you should have gotten a form 5498 detailing your year-end balance, any contributions you made, and some other information). The rules for computing the RMD from your age and that balance depend on a couple of factors, but for most folks, it's very simple. See IRS Pub 590 for details.
You can take more than the RMD, but if you take less, the penalties are steep - not only do you still need to take the required money out - and pay taxes on it - but you'll potentially owe a penalty as much as 50% of the amount you were required to take out but didn't. If you turned 70-1/2 in 2010, you actually are permitted to delay that first RMD until April 1, 2011, but you probably don't want to - because you'll need to take an RMD for 2011 in 2011 as well, meaning you'd have to take two RMDs in 2011. Unless you know that you're going to be in a much lower tax bracket in 2011, there's no reason to delay. And if you turned 70-1/2 before 2010, you don't have a choice - your RMD for 2010 has to come out during 2010, meaning you have only a few weeks to take that distribution. If you're not sure what needs to come out, talk to your advisor or planner, or talk to your IRA provider - they all are happy to help with the calculations - or if you have money in an employer-based plan, contact them. If you're over 70-1/2 and still working for that employer, you may not have to take RMDs yet. But if you are no longer working for that employer, you are going to be subject to RMDs, too, and will have to deal with that former employer. Contact them and consider rolling the money over to a self-directed IRA so you don't have to deal with that former employer anymore.
But no matter what your situation - if you have any retirement accounts and are over 70, make sure you know what your RMDs are and that you've taken the distributions. The cost of failing to do so is very very high.
For more information about RMDs, see the IRS's Publication 590. (a PDF copy may be downloaded from here: http://www.irs.gov/pub/irs-pdf/p590.pdf