The media today is full of discussion regarding the ever-increasing national debt.  Between the cost of ongoing wars in Afghanistan and Iraq and stimulus spending to support and grow the US economy, it is clear that, at least for the present time, deficit spending is an unfortunate fact in our country.  The cost of this deficit must be paid at some point, and as a result, increased income tax rates are a near certainty in the future of the US taxpayer.

What tax increases should be expected?

With the Bush era tax cuts set to expire at the end of 2010, increased rates will apply for 2011 unless Congress intervenes to extend the current marginal tax rates.  Budget proposals promulgated by the Obama administration call for limiting tax increases to apply only to high-income households – beginning at $200,000 for individuals and $250,000 for joint filers.  Under these proposals, tax rates on the top marginal brackets will increase from 33% and 35% to 36% and 39.6%, respectively.  Furthermore, the tax rate for long-term capital gains will increase from 15% to 20%.

Medicare tax increases enacted as part of healthcare reform will also impact high-income households in the near future.  Beginning in 2013, an additional 0.9 % tax will apply to wages and self-employment income in excess of $200,000 for individuals and $250,000 for joint filers.  Unearned income such as interest, dividends, and rental income will also be subject to additional Medicare liability of 3.8% to the extent  modified adjusted gross income exceeds $200,000 for individuals and $250,000 for joint filers.

Although these tax increases are likely inevitable, with some effective planning, smart taxpayers can at least capitalize on the knowledge of the coming changes and perhaps mitigate the impact of the increases on their finances.

Tax planning strategies addressing increasing tax rates

The following are some suggestions of tax-planning techniques and strategies that might be useful in an environment of increasing tax rates.

1.  Consider accelerating recognition of income and delaying income tax deductions.  Traditional wisdom holds that it is almost always beneficial to defer the recognition of income until later years and enjoy the benefits of tax deductions as soon as possible.  The time value of money demonstrates that a dollar spent in the future costs less than a dollar spent today.  However, when future tax rates are likely to be anywhere from 2% to 9% higher than current tax rates, it is difficult for the return on the deferred expenditures to outweigh greater tax cost in the future.

In utilizing this strategy, it is extremely important to project income and expenses as accurately as possible.  Clearly if income in future years is expected to be dramatically lower than in the current year, such as after retirement, then it will likely still be beneficial to minimize the current year income.  This type of planning is all about recognizing and exploiting the various marginal tax brackets over a period of years.

2. Rearrange your investment portfolio to take advantage of retirement accounts.   Concentrating investments paying current income in your deferred retirement accounts and making growth-oriented investments intended to generate capital gains in taxable accounts can help to limit the impact of income taxes.

Even under the currently proposed tax increases, long-term capital gains will be taxed at lower rates than ordinary income.  All income earned inside of a qualified retirement account, even capital gain, is taxed as ordinary income when it is distributed, thus eliminating the benefit of the long-term capital gain tax rate.  Also, capital losses realized inside of retirement accounts cannot be used to offset other capital gains.

3. Shift income to lower tax bracket family members.  Although the “kiddie tax” rules require much of the unearned income of dependent children to be taxed at their parents’ marginal tax rates, gifts of income-producing assets to other family members can still be an effective tax reduction strategy.   The “kiddie tax” allows for up to $1,900 of a dependent child’s unearned income to be taxed at the child’s lower marginal rate.  Once the child is of age (19, or 24 for full-time students), and earning income to provide their own support, the unearned income will then be taxed at their lower marginal rate.

Parents or other family members may also be good candidates to receive gifts.  This is particularly true if the high-income taxpayer is providing any funds for the care and support of the older relative.  Rather than contributing funds out of after-tax income, a gift of an income-producing asset can reduce the family’s total tax burden and provide a source of ongoing support.

For business owners or self-employed taxpayers, income can also be shifted to lower tax bracket family members by hiring them to work in the business.  The higher income taxpayer can take a deduction for the wages paid to the lower income family member.  Taxable wages are earned income and as such, are not subject to the “kiddie tax” calculation.

The effectiveness of these strategies or any other technique is dependent on each taxpayer’s particular situation.  A qualified tax advisor should be consulted in order to evaluate the appropriateness of any tax-saving technique.