Last Minute Tax Tips

The government remains open for business, and your taxes are due soon.  This year it is delayed a little bit, to April 18^th.  (One more weekend of going to the office for me!) So there is a little time to do some last minute “planning” -- or should we say remediation -- presumably last-minute and planning can’t really be combined. 

First off – while it’s too late for the Roth conversion deal (two years to pay the tax liability if you converted a traditional IRA to a Roth before 12/31/10) you can still take a 2010 deduction by contributing to a traditional IRA by the 18^th.  The same holds true for contributing funds to a qualified Health Savings Account ($6,150 for family, $3,050 for individuals). 

Another good reminder is to make sure you’ve got all your charitable donations noted.  If you give via payroll deduction, you don’t get a letter, but you can count the donation as an offset to your taxable income.

Not to encourage marital strife, but it’s worth checking to make sure filing jointly is the best plan.  One example where this might work is if one spouse has fairly big medical bills, but the couple’s combined income makes the threshold for getting the medical deduction out of reach.  This is not a one-variable decision, so you need to see the final difference on the return before you make a change.  Still – it’s worth checking.

Finally, this little nugget from the GAO in their report to Congress on how the IRS is doing this year.  While avoiding a shut down, apparently the IRS is hampered by restrictions on checking for mathematical errors on returns, unless they do a full audit.  According to the report, if the IRS doesn’t have the permission in the existing 13 Math Error Authority designations, they can’t check for a mistake (or fraud) unless the return gets audited.  An example cited in the report is for the Residential Energy Credit, which this year had a lifetime cap put on of $1,500.  I checked a number of returns this season to make sure the limit wasn’t exceeded.  Apparently the IRS won’t be doing the same.   It’s awkward to advocate for tax compliance when the government doesn’t even pretend that enforcement is consistent.    (Oops, more late tax season crankiness!  Good thing we’re almost done.) 

Tax Planning Thoughts

While you don’t have to make a final decision until the end of the year, it is worth taking some time now to think about converting your traditional IRA or other tax qualified retirement plan to a Roth IRA.  This decision process requires many assumptions.  My preference is using facts to make financial decisions, but sometimes that option just isn’t available.   

A quick summary on traditional qualified plans vs. Roth IRAs yields the following bottom line.   Are you better off deferring taxes until you are age 70 ½ or should you get it over with now, and then get tax-free distributions from your retirement savings?

• The IRA / qualified plan money is contributed on a pre-tax basis.  If it stays in the plan until after you are 59½ years old, you will pay taxes on withdrawal.  If you try to take the money out earlier, you pay the taxes plus a 10% penalty.  Once you reach age 70½ you have to start taking a specified portion in distributions, as the IRS is done waiting to get the taxes due on that money.  You age-out of being able to contribute to a traditional IRA once you have to take those mandatory distributions
• With a Roth IRA, the contributions are made after taxes.  Earnings may be withdrawn without tax or penalty if you meet the 59½ age threshold and the money has been in the account at least five years.  There are no mandatory distributions.  So while you don’t get the turbo charge of pre-tax contributions and then getting deferral on the growth, on the other hand, what is in the account is yours to keep.    The Roth IRA doesn’t have an age restriction for contributions, but there are income limits that cause many upper income people to be ineligible for this type of plan. 

This brings us to 2010 -- a year that is notable because the income limitations on converting qualified retirement plans to a Roth have been removed.   This means you can roll over money in other qualified pIans regardless of your income.  In addition, moving the IRA into a Roth will not trigger tax penalty even if you haven’t reached the age where the IRA can be accessed.  However, all taxes owed must be paid.  If you make the decision to do this before the end of 2010, you can elect to pay the taxes over two years -- waiting to make the payments in 2011 and 2012.

Here’s where the assumptions stuff comes into play.  Normally, using the time value of money approach to managing your finances, paying later is always better.  However, if the Bush tax cuts expire in 2011, you could pay more in taxes that year than you would have if you took the hit in 2010.  Another assumption to watch out for is the Medicare surtax on investment income.  This tax is scheduled to start in 2013, and if you are in a higher income bracket you won’t pay it on your Roth distributions, but you will on your traditional IRA. 

One offset to all the crystal ball gazing skills involved in the conversion decision is talking to a tax advisor.  While it’s still an assumption, I’m convinced a thorough review of all your specific considerations this year is an especially good investment.