The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act) provided us with some certainty as we head toward 2012. Various expiring tax cuts were extended and remain in effect through the end of 2012, and many advisors predict that significant changes in tax law will not occur until after the November 2012 Presidential election. However, warnings are abundant that we may experience higher tax bills for 2013 and beyond.

Below is a brief summary of current tax law, including planning tools to help reduce your 2011 tax burden, and ideas to assist with your tax and financial planning in 2012.

Individual marginal tax rates for 2011 are unchanged at 10%, 15%, 25%, 28%, 33% and 35%. As things stand right now (thanks to the 2010 Tax Relief Act), 2012 tax brackets will continue at these same levels.

For 2011, long-term capital gain and qualified dividend rates are 0% and 15%, depending on income levels. These rates remain effective through the end of 2012, but we should anticipate that long-term capital gain rates will jump in 2013, and that we will lose the favorable lower tax rates for qualified dividends, with this income most likely reverting to taxation at ordinary income rates.

AMT rates for 2011 remain 26% and 28%, depending on income levels. Exemption amounts are $74,450 for married couples and $48,450 for single taxpayers in 2011. However, without the adoption of a patch by Congress for 2012, the exemption amounts will drop dramatically to $45,000 for married couples and $33,750 for single taxpayers. This would mean a tax increase of thousands of dollars for many taxpayers in 2012. Typically an annual patch is approved, but with the lack of cooperation amongst politicians, it is not wise to plan on relief any time soon.

Personal exemptions, indexed for inflation, increased from $3,650 in 2010 to $3,700 in 2011. The phase-out for exemptions is still eliminated for 2011 and 2012, and, in theory, this means that all taxpayers should receive the full benefit of their deductions, regardless of income level. However, keep in mind that AMT can cause less than full realization of tax benefits from personal exemptions.

The 2011 standard deduction amounts, indexed for inflation, rose to $11,600 for married filing joint, $5,800 for single taxpayers, and $8,500 for head of household.

Although tax brackets are adjusted annually for inflation, there is no difference in the tax rates that apply for 2011 and 2012. Therefore, no dramatic action is needed. However, with the possibility of significant tax increases in 2013, it might be prudent to focus 2011 and 2012 tax planning on accelerating income and postponing deductions. When developing your year-end planning strategy, be sure to consider the following Alternative Minimum Tax (AMT) wrinkles:

Try shifting income and expenses between tax years using a tax program, to be certain your tax planning efforts produce a positive impact over a two-year period, or consult with your tax advisor.

FICA taxes (the combined rate for Social Security and Medicare) remain at 7.65% (15.3% for self-employed persons). For 2011, there was a 2% reduction in the employee portion of the Social Security tax, but unless Congress acts, the reduction will not be extended into 2012.

The 2012 maximum Social Security earnings limit increases for the first time in 3 years, from $106,800 to $110,100. Medicare tax payments continue on all wages.

The age at which full benefits are available (full retirement age) has been increased from age 65 to 67, on a phased-in schedule. This affects everyone born after 1937 and varies based on the year of birth. For those born between 1943 and 1954, the full retirement age is 66. Although early retirement at age 62 is still possible, benefits are reduced.

Retirees who have reached full retirement age may work without any reduction in Social Security benefits. However, the earnings limit still applies to workers who have not reached full retirement age. In 2012, benefits are reduced $1 for every $2 earned over $14,640 for those age 62 to full retirement age. In the year full retirement age is reached, benefits are reduced $1 for every $3 earned over $38,880, but only earnings before the month you reach full retirement age are subject to the reduction.

There is no change in the computation of how much Social Security will be taxed for 2012. For those with "provisional" income above $44,000 ($34,000 if single), you will be taxed on 85% of those benefits. The 50% tax rate remains for income between $32,000 and $44,000 ($25,000 and $34,000 if single). This differential in tax rates makes it very important to plan receipt of income to take advantage of the 50% rate.

In 2011, for children under 18 and full-time students under 24, the "kiddie tax" rules are as follows:

These "kiddie tax" rules mean you need to be careful before shifting income to children. However, hiring your children in your business can still yield good results.

Retirement contributions (whether 401(k), 403(b), profit sharing, pension, SEP, or SIMPLE) still provide a major opportunity to reduce your tax bill. Whether pretax or post-tax, if you have an employer sponsored salary deferral plan, in most situations it makes sense to maximize your contributions. Contribution limits to 401(k) and 403(b) plans for 2011 are $16,500 and increase to $17,000 for 2012. If you are age 50 or older, the additional annual allowable "catch-up" contribution is $5,500 for both 2011 and 2012.

For business owners, the maximum you can contribute to a qualified retirement plan for 2011 is the lesser of $49,000 ($54,500 with "catch-up"), or 25% of your compensation. For 2012, this limit increases to $50,000. The maximum compensation level for computing your contribution is $245,000 in 2011 and increases to $250,000 for 2012.

The maximum IRA deduction is $5,000 for 2011 and 2012, but if you are age 50 or older by year-end, you can contribute up to $6,000.

For 2011, traditional Individual Retirement Account (IRA) contributions are not deductible if you and your spouse are covered by a company retirement plan and your combined income exceeds $110,000 for married filing joint, or $66,000 for singles. The married filing joint threshold increases to $112,000 for 2012, and the single threshold increases to $68,000.

However, a deductible IRA is allowed if one spouse is covered by an employer-sponsored plan, but the other is not, as long as Adjusted Gross Income (AGI) is less than $179,000 in 2011 and $183,000 in 2012.

If you are prohibited from deducting IRA contributions, you may still make nondeductible contributions. Earnings on these contributions accumulate tax-free until they are withdrawn. If you make nondeductible IRA contributions, keep a record of contributions using IRS Form 8606 to be certain that you are not taxed on this money when it is withdrawn.

Do not forget that non-working spouses are allowed to contribute the full amount to an IRA account, whether deductible or not, as long as the other spouse has sufficient earned income. This is an excellent opportunity to shelter additional income and allow earnings to accumulate tax-free.

If your AGI is below $179,000 ($122,000 for singles), a Roth IRA should be chosen instead of a nondeductible traditional IRA, because earnings on a Roth IRA can escape taxation when withdrawn.

With the income ceiling for Roth IRA conversions lifted, a determination should be made on an annual basis to see if it makes sense to convert traditional IRA accounts to a Roth IRA, paying more taxes now to avoid paying taxes later.  The decision to convert is complex and involves many factors, such as your time horizon, tax bracket now versus tax bracket when retired, your age, marital status, the impact of Alternative Minimum Tax and whether you believe Roth IRAs will remain untaxed in the future.  The ideal candidates for conversions are:

Converting a large amount of IRA funds may cause you to jump into a higher tax bracket. Therefore, choosing to convert a modest amount over a period of several years may provide a better result.

If you convert early in the year, and there is a market downturn, you may consider re-characterizing, pushing the Roth IRA back into a traditional IRA so that you won’t be paying tax dollars on a drop in account value. You can then "reconvert" the account in the following tax year. To hedge your bet, consider segregating your traditional IRA into separate accounts by asset class prior to converting to a Roth. This will allow you to re-characterize some portion of the funds (but not necessarily all) based on market performance.

Your decision to convert a traditional IRA to a Roth IRA needs thoughtful consideration and we suggest you contact your tax advisor or financial advisor to prepare a careful analysis that weighs all of the above issues.

Section 529 plans (like EdVest in Wisconsin) have become the most popular way to save for college. Contribution limits are generous, there are no income limitations, and withdrawals used to pay college costs are tax-free. Most states also permit a tax deduction for 529 plan contributions. Contributions must be made by December 31 each year, and withdrawals may only be used for post-secondary educational expenses.

For 2011 and 2012, qualifying dividends are taxed at a top rate of 15% (or 0% if your tax rate is 15% or less). Likewise, long-term capital gains are taxed at 15% (or 0% if your tax rate is 15% or less). The best strategy remains as follows:

Generally it is not a good idea to make after-tax investments in mutual funds near year-end because mutual fund companies distribute capital gains to shareholders near the end of the year.  This means that you could end up paying tax on an entire year of capital gains even if you did not receive any cash, and even if you owned the fund for only a few days. Even if a mutual fund experienced losses in 2011, the fund could still generate capital gains. To find out when capital gains will be posted, call your broker, or look at the website for your mutual fund company.

With some investments still down, this might be a good year to sell those securities that have decreased in value, if you can recognize some losses for tax purposes.  One popular year-end strategy is to sell stocks or mutual funds where there are losses and buy similar (not the same) stocks or funds to maintain your position. 

Record-keeping is important when you purchase and sell investments.  In fact, the IRS has initiated new rules requiring financial institutions to provide cost basis on 1099 forms. Although this is intended to assist the IRS in return processing and simplify record-keeping for taxpayers, it has complicated the reporting for investment transactions during the phase-in period and Schedule D reporting is more complex, now including a new Form 8949. You should have already been contacted by your financial institutions to clarify your preference in method to be used for cost basis reporting.

Your choice of cost basis reporting can affect your tax bill.  When prices on your investments are rising, the last-in, first-out method results in the lowest tax bill.  With a falling market, the first-in, first-out method is likely to result in the lowest tax bill. Most mutual funds will provide cost basis data calculated using the average cost method. If you have sold shares of the mutual fund in the past, you must continue to use the average cost method, and cannot switch to another method without IRS permission.

Short-term and long-term gains and losses continue to be netted together, and net long-term losses are deductible to a maximum of $3,000 per year, with an indefinite carry-forward.  Also remember that brokerage costs decrease your taxable gain, and bonds purchased between interest dates require an interest adjustment for tax purposes.  If you have questions, call your financial advisor. 

The Internal Revenue Service allows one extra payment of monthly interest in one year. Therefore, if you make your January loan payment before

December 31, it can be deducted this year. Be sure to verify that your lender has reported this payment correctly when they mail you your statement at year-end. Because of mail delays, send your payment on or before December 21, 2011 to allow enough time for it to be credited to your account before year-end.

You may deduct 14 cents per mile for travel in providing services to a charitable organization.

If payment for a charitable contribution is mailed or charged to a credit card before December 31, the deduction can be taken in the current year.

There is a bonus if you donate, to a qualified charity, stocks or mutual funds that have increased in value, and have been held for more than 12 months. You can deduct the full fair market value of the security and avoid paying capital gain tax on the appreciation. The strategy of donating securities works best for shares that have increased in value. If you have shares to donate that have dropped in value, you are better off selling these shares to recognize a tax loss, and then contributing the cash to the charity.

Every cash donation must be supported by a cancelled check, credit card receipt or written communication from the charity. Moreover, to be deductible, non-cash clothing and household donations must be in at least "good condition". Remember, if you have total non-cash contributions of $500 or more during the year, some additional information is needed about the donations, such as how you determined the worth of the donated property, what it originally cost, and how you acquired the property. If your gift is over $5,000, an appraisal is required, and specific rules about the value of your deduction now apply to donations of vehicles.

Keep in mind, you must obtain a written receipt from charities for all gifts over $250, as a cancelled check is not considered sufficient support. Also, for non-cash gifts, the receipt must describe the gift in detail, but it need not confirm its value.

Finally, if you receive something in exchange for your donation, say a meal or a complimentary ticket, the charity must tell you in writing what portion of your donation is deductible.

Only medical expenses in excess of 7.5% of Adjusted Gross Income are allowed as a deduction. In most cases, this means you receive a tax benefit only when there is a major illness. The standard rate for use of your car for medical reasons (or when computing deductible moving expenses) is 19 cents per mile for January through June, 2011 and 23.5 cents per mile for July through December, 2011. This rate drops to 23 cents per mile beginning January 1, 2012.

Casualty losses, such as flood damage are allowed, but only if losses exceed 10% of Adjusted Gross Income.

Miscellaneous deductions (such as IRA fees, subscriptions to trade magazines, tax and investment advice, safe deposit box fees and employee business expenses) must exceed 2% of Adjusted Gross Income before they are deductible.

Certain credits for residential energy-saving improvements and energy-efficient property, such as home insulation, new windows and doors, HVAC and roofing are still available through the end of 2011. There are numerous limitations associated with each type of credit, so a close review of the rules will be needed to determine the amount of your credit.

Most rental real property is considered a "passive" investment. For Adjusted Gross Income under $100,000, up to $25,000 of losses are deductible, but only if you actively participate in managing the property.

For Adjusted Gross Income over $100,000, the deduction is phased-out, with no deduction available for taxpayers having income over $150,000. However, you can deduct all rental real estate losses from regular income (and the $25,000 loss limit does not apply) if you spend over half your total working time (at least 750 hours a year) on realty development or management.

For 2011 and 2012, all individuals are eligible to give $13,000 per year to as many persons as they wish and avoid gift taxes. Married couples can contribute up to $26,000 per year to one individual and avoid gift taxes. In addition to these limits, tuition and medical expenses paid on someone’s behalf also avoid gift and estate tax, regardless of the dollar amount, as long as the payments are made directly to the educational or medical institution.

Most people do not realize that life insurance proceeds paid to your beneficiary may be taxed as part of your estate when you die. In addition, proceeds from IRAs and retirement plans are taxed twice when you die, once as part of your estate, and once on the beneficiary’s tax return. Consult your estate planning attorney for details, and techniques to avoid double-taxation.

For 2011 the federal estate tax is imposed on assets of $5 million or more at a maximum tax rate of 35%. For 2012, this amount increases for inflation to $5.12 million. However, after 2012 many experts predict that Congress will lower the exclusion amount to $3.5 million and raise the top tax rate to 45%. For many these potential changes mean that the concern for estate tax issues should not be ignored.

If you have not had an estate planning attorney review your situation in the past few years, now would be a good time to do so.

The deduction for business meals and entertainment continues to be 50%, but you may not claim any part of club dues, even if your membership is solely for business reasons. In addition, business travel deductions are limited

to expenses for yourself and your employees. You are not allowed to claim expenses for a non-employee spouse, dependent or other traveling companion.

Receipts are not required (but are recommended) for business expenses under $75. However, upon audit you still need some evidence to support the expense.

The standard mileage rate for business use of an automobile is 51 cents per mile for January through June of 2011, and 55.5 cents per mile for July through December. The standard mileage rate for business use of an automobile remains 55.5 cents per mile for 2012.

For 2011, Form 1099-MISC is required for all purchases of services over $600, unless you paid the money to a corporation. One exception - Form 1099-MISC needs to be issued for legal services, even if the law firm is a corporation.

Reporting changes requiring 1099 forms to be issued for the purchase of all goods and services over $600 were repealed by Congressional action. However, the penalty increases for non-filing or untimely filing of required 1099 forms still apply and range from $30 per form to $250 per form.

Don’t forget that Wisconsin and most other states continue to have a strong focus on "Use Tax". If you make any out-of-state purchases (using the Internet or catalogs for example) without the payment of sales tax, you should be reporting Use Tax on your state tax return. In an attempt to increase revenue generation many states continually update sales and use tax legislation, and careful attention should be paid to what items are considered taxable. For example, in Wisconsin, use tax applies to the sale of, and the storage, use, or other consumption of, digital goods. This means that iTunes and movie downloads are taxable.

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Happy holidays and best wishes for the start to a healthy new year!

Arnow & Associates

7402 North Seneca Road

Fox Point, Wisconsin 53217

(414) 964-4000

www.arnow.com

We are required by Internal Revenue Service regulation to include a disclaimer whenever certain types of written advice are provided. To the extent this document contains written advice relating to a matter of Federal tax, this advice is not intended, was not written to be used, and cannot be used by the intended recipient or any other taxpayer, for the purpose of avoiding Federal tax penalties.

The information contained in this document does not cover all tax strategies that may apply, is not a complete guide to tax planning, and does not constitute the rendering of legal, accounting, or other professional advice or opinions on specific facts or matters. Before implementing any ideas suggested here, consult with your tax advisor regarding your specific tax situation.

LJA xtax2 11/21/11