GreenTraderTax Blog
GreenTraderTax
Year-end tax planning, part 1

September 23, 2009

Most years, taxpayers take every opportunity to kick the tax-can down the road, by deferring and accelerating income. This year and next should be different, because tax rates are likely heading higher for the upper and middle class starting in 2011.

You have two choices this year-end. Minimize 2009 taxes as best you can to safeguard cash flow — paying as little taxes as possible and maximizing your refund. Or, view your tax situation over the next several years and minimize taxes over the long term. That second choice may mean accelerating income into 2010 to pay more taxes at lower tax rates vs. higher tax rates later on.

There are few ways that investors can follow this cash out strategy — by cashing out long-term investments earlier than planned or with a Roth IRA conversion.

Tax rates are on the rise.
The Bush tax cuts are set to expire in 2011. President Obama promised no tax rate increases on the middle-class, so only the upper two marginal income tax brackets are scheduled (in the Obama 2010 budget) to increase to 39.6 percent from 35 percent and 36 percent from 33 percent. The highest long-term capital gains tax rate will rise 5 percent to 20 percent. The House proposed a further increase to 24 percent to help finance health care reform.

Democrats currently have the power to enact their vision of fiscal (tax) policy. A common Democratic belief is supply-side economics only benefit the upper class and don’t trickle down to the middle-class and poor.

Conversely, Republicans tend to believe supply-side economics lifts all boats, and lower tax rates spur entrepreneurial-led growth, which creates jobs and raises absolute tax revenues. It’s always been difficult to prove who is right on these points.

Congressional leaders and President Obama are under pressure to lessen the escalating budget deficit. At the same time, leaders are proposing new spending programs — stimulus for the recession, health-care reform, and financial reform regulation. In the Democrats view, raising taxes on the rich is required to “pay go” for this new spending.

Many pundits have said President Obama may need to break his promise on raising taxes on the middle class too. Presidential surrogates have not denied this when asked about it on Sunday talk shows.

For a good short history of income tax in the US, see http://www.infoplease.com/ipa/A0005921.html .

With taxes headed higher, consider cashing-out your taxable portfolio now.
With the long-term capital gains rate scheduled to rise to 20 percent in 2011 (from 15 percent), consider selling long-term capital gains positions before year-end 2009 if the markets are at high levels. Holding short-term positions into 2010 to gain long-term status is another potentially worthwhile strategy; you can sell these positions before year-end 2010 and avoid the tax increase in 2011. The goal is to pay more taxes at lower tax rates vs. higher tax rates later on.

Cash out your retirement funds with a Roth retirement account conversion.
This same concept can be applied to your traditional retirement plan accounts in connection with a year-end Roth IRA conversion.

Traditional retirement plans have different tax benefits from Roth IRA plans. Traditional retirement plans offer tax deductions on annual contributions and temporary tax-free income build-up in the retirement account until you take ordinary income taxable distributions at retirement age (as early as age 59 ½ and no later than age 70 ½ ). Roth IRAs and Roth Mini 401ks have a different tax bargain. Rather than getting tax deductions up front for contributions, the Roth accounts are tax free for life.

The key difference is the permanent tax-free status on the contributions. In the traditional plans, the funds are ultimately taxed in retirement, and tax rates are forecasted to be higher when you retire. Conversely, with the Roth plans, the funds are never taxed at retirement age. We advocate a simple strategy: make annual tax deductions to a traditional retirement plan during high-income years (when you pay taxes at higher tax rates) and in years when you have losses, convert to a Roth IRA, paying taxes at lower rates. The goal is to get more assets into the Roth accounts.

Roth retirement accounts are attractive to traders because their “stock-in-trade” (business) is managing a portfolio for (active trading) growth and unlike all other types of taxpayers, they can escape taxes on their stock-in-trade.

Many situations call for taking advantage of the tax deduction on a traditional retirement plan contribution too. Traders need to financially engineer earned income with a fee or payroll in their own trading entity, as trading gains are not earned income. That earned income triggers self-employment (SE) taxes. Generally, a traditional retirement plan deduction saves more in income taxes than the trader must pay in SE taxes.

In years with large trading losses, which lead to material business net operating losses (NOLs), it may also be prudent to soak up the NOL with a Roth conversion, instead of filing a NOL carry-back refund claim return. Full-time and very active business traders don’t need to worry about the IRS as much and NOL carry back returns are generally better for them.

Roth IRA distributions can also prevent Social Security benefits from being subject to income tax. If combined AGI is more than $44,000 (2009 threshold), up to 85 percent of Social Security benefits are subject to income tax. If under the threshold, social security benefits are tax-free. Roth IRA distributions can help taxpayers qualify for other middle-class tax breaks too (also dependent on AGI).

Can the Roth tax pledge be trusted?
Some traders tell me they worry about the government will eventually decide to tax the income build-up in a Roth IRA. It can’t tax the original contributions, as they were not tax-deductions and paid for with after-tax dollars.

I highly doubt this will happen. The government wants to provide incentives for saving for retirement. Curiously, to save on cash flow, the government recently announced a new program offering taxpayers an option to divert a portion of their tax refund to their retirement savings account, instead of getting a tax refund. It reminds me of states such as California issuing IOUs for tax refunds in 2009.

Everyone can convert to a Roth in 2010.
The last scheduled juicy tax break from the Bush administration is the Roth IRA conversion loophole in 2010, waiving the normal “income threshold” for 2010 only and making it possible for any taxpayer (even otherwise barred married filing separate taxpayers) to convert to a Roth IRA. For any other year, the income threshold rule only allows the Roth conversion option if the taxpayer has a modified adjusted gross income (MAGI) of $100,000 or less for both joint and single filings.

The biggest drawback to the Roth conversion is you need sufficient cash flow to pay the conversion income taxes; you can’t use the converted amounts to pay those taxes, either. But the 2010 tax break also allows you to pay the conversion taxes over two years; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. Taxpayer's in the upper-two brackets (being raised in 2011) can opt out of the two year tax deferral, so they don't pay taxes at higher rates.

Qualified plans (like a Mini 401k), a SEP-IRA, or SIMPLE IRA may be converted to a Roth plan too.

A conversion from a regular IRA to a Roth IRA is subject to tax as if it were distributed from the traditional IRA, but at least it isn't subject to the 10% premature distribution tax (which otherwise would not apply if the taxpayer was over age 59 1/2).

Roth do-overs
Suppose you convert to a Roth IRA before year-end, pay taxes on the converted amounts, and then face a large loss on the Roth trading account. It could be from actual active trading losses or the market dropping in value. This unfortunate loss on permanently tax-free money can’t be deducted on your taxes.

Not to worry, there’s a fix: The IRS allows taxpayers to change their minds. The process is known as a Roth IRA recharacterization. Learn more at www.irs.gov and search Roth IRAs.

Generally, a taxpayer has until Oct. 15 of the following tax year to undo a Roth conversion. For example, a Roth conversion completed in December 2009 may be recharacterized by Oct. 15, 2010. If a taxpayer already filed his or her 2009 tax return before Oct. 15, 2010, the return can be amended, but it’s better to wait with an extension.

Just ask your administrator to do a "recharacterization."

Bottom line on the Roth conversion strategies.
If you qualify for a conversion, try it in 2009. Maybe the converted assets will rise in value. If they drop in value, consider a recharacterization for 2009 and possibly converting again in 2010 with the lower asset values.

If you skip the Roth conversion strategy, you may wind up taking traditional retirement plan distributions subject to much higher tax rates. Also note that lower 60/40 tax rates on futures and electing forex traders are not available on retirement plan distributions.

Here’s another good article: http://www.nytimes.com/2009/07/18/your-money/individual-retirement-account-iras/18money.html?_r=2&nl=your-money&emc=your-moneyema2 .

Check back later this week for more year-end tax planning tips.

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