A quick review of the highest tax brackets tells the tale. Tax rates on regular income will increase to 39.6% next year, from 35% this year. Since income will be taxed at higher rates next year, deductions will save more next year also.
There is another tax bracket jump in 2013 when an additional 3.8% Medicare tax is imposed on investment income and another .9% Medicare tax is imposed on earned income (wages). And don't forget that capital gains rates go to 20% in 2011 from 15% this year, and then will get hit with an additional 3.8% in 2013 (for a 23.8% tax rate within the next three years. )
The two-phased tax bracket jumps (2011 and 2013) mean that you need to be thinking of multi-year strategies.
Accelerating income can be tricky and goes against most instincts. Business owners have the most flexibility. They can bill earlier and try to collect prior to year-end. Salaried employees have few opportunities to accelerate income, except perhaps stock options.
By exercising stock options during 2010 (rather than 2011 and beyond) the income might be taxed at a 5% lower rate. The most critical issue with stock options is, of course, the share price. A stock price increase after 2010 could easily erase any additional income taxes associated with the option exercise.
For example, say an employee has an option on 1,000 shares with an option price of $20 and the current price is $35. After 35% income taxes, he would net $13,000 if he exercises the option in 2010. But if he waits until 2011, and the price goes to $38 per share, he will pay taxes at 39.6% but he will net $13,892. This employee needs to think about whether the stock price has the potential for increasing after 2010.
For those doing a Roth conversion, there is the opportunity to pay tax in 2010 or spread the income into 2011 and 2012 (at higher tax rates). If you are already in the maximum tax bracket it might make sense to pay the tax today and not take advantage of the two-year spread alternative. For those who are not in the maximum tax bracket, some projections of 2011 and 2012 income tax are in order (it may make sense to take advantage of the two year spread).
For those with significantly appreciated assets there are several things to keep in mind. First, think about a 5% higher rate in 2011 (15% versus 20%) and an 8.8% higher rate in 2013 (15% versus 23.8%). You need to factor in how soon you might otherwise sell the asset and compare rates and use of money considerations. As with the stock option exercise example, a rise in the asset value could easily erase the added tax burden.
Deductions go further when tax rates are higher. It makes sense to delay deductions into 2011 and beyond. The only danger with this strategy is that a 2009 proposal from the Obama Administration was to cap the tax benefits of deductions at a 28% rate. But, this proposal has gone nowhere.
Start thinking about what expenses can be delayed until 2011. Business owners should consider what supplier payments can be delayed later this year (or partial payments made). This is especially important for cash method taxpayers. Accrual method taxpayers need to plan well ahead when it comes to expenses. Put the checkbook away in November and December. Don't pay real estate taxes that can be delayed until 2011. Delay charitable contributions until 2011 when possible.
Examine what variables are within your control-income and deductions. Do a multi-year analysis to determine tax brackets in 2010 and 2011. Set up a plan now with planned execution dates between now and the end of the year.
Bill Fleming, CFP, is a managing director in
PriceWaterhouseCoopers Private Company Services Practice.
He joined PwC in 1987 and is based in Hartford, Conn.