It may be a good idea to pay more tax this year. This is not what you usually expect to hear from an accountant. However, when we are planning in a time of potential tax rate increases it may be the perfect time to recognize more income and pay tax now at a lower rate.
Bush-era tax cuts will expire if Congress takes no action by the end of the year, resulting in major increases in income, estate, dividend and capital gains taxes, along with more than 50 other major changes in the Federal Tax Code.
While some members of Congress have advocated for an extension of current tax rates to stimulate economic growth, Congress took no action before its pre-election recess. An extension of the current tax rates is still possible but it's a good idea to prepare for the worst.
So what can you do to help your clients prepare?
Regardless of what happens, it is important to help your client develop a plan. Make certain you understand your clients' financial goals and objectives, and know what matters most to them.
Once a plan is in place, many actions can be taken, but we'll focus on five ways to prepare.
1. Convert traditional IRAs to Roth IRAs. Even if Congress were to extend the tax cuts, taxes are likely to increase in the long term to fund the national debt and as health care reform kicks in. Medicare is practically insolvent, and a 3.8% tax on investment income is scheduled to begin in 2013 to help fund it. Medicaid and Social Security are also approaching insolvency and we'll also have to find a way to deal with long-term care and underfunded pension plans.
So wouldn't it be nice to have a source of retirement income that will be tax free, regardless of future tax rates?
Although funds invested in Roth IRAs are taxed up-front, they can grow without being subject to additional taxation. Owners of Roth IRAs are not required to take required minimum distributions and Roth IRAs can even be transferred to heirs, although heirs will be required to take minimum distributions. Since income from Roth IRAs is not included in AGI for calculating federal income taxes, it can also be used in combination with distributions from other retirement accounts to lower the account holder's tax rate during retirement.
Until 2010, conversions were allowed only for taxpayers with adjusted gross income (AGI) of less than $100,000 a year. Now anyone can convert traditional IRAs to Roth IRAs.