While the Congress is in recess until mid-September and most Americans are on holidays, for investors it is now the best time to hedge your bets for 2011 and engage in mid-year financial planning activities. Of course the best tax planning never really stops, but 2010 is a very special year and you need to be extra vigilant.
The controversial tax breaks put in place by George W. Bush are set to expire at the end of 2010 and estate taxes kick in with your first heartbeat in 2011 (sorry to break the news).
If you are on the payroll of a company which someone else controls then your leverage in tax optimization–which was ruled your constitutional right by the Supreme Court, so long as you follow the rules, which you should do in your own best interest–is rather limited. On the upside, you can enjoy a rather stable and predictable stream of income. You can probably quite easily estimate this year’s total income already. Double your income to date, throw in some year-end or Christmas bonus for good measure and you are pretty close to the numbers you are going to see.
If you run a small business, however, you may not be able to accurately predict your earnings for the rest of the year. But you can at least add up the salary you have paid yourself in the first two quarters of the year and double this number, hoping for the best. This way you can review your estimated tax brackets and calculate your federal tax rate in advance to avoid surprises.
This is not only relevant when you are either self-employed but also if you have performed quite well on the stock and commodities markets and racked up–hopefully awesome–capital gains. As a business owner and investor you may not know the final number yet but you have more influence over your tax fate not to mention your income. Let’s assume you got into the stock market in early February when the Dow Jones Industrial Average was depressed and hovering clearly below 10,000 (at about 9,908). Hopefully you got out in late April at around 11,100. Even if you missed your exit this time around, in early May there was the next exit at around 10,896. If you managed to take your money off the table in time, you are deep in black. Luckily, the stock market provides multiple entry and exit points and so even if you missed the exit from the April rally you could still get a nearly unblemished track record by getting out on August 9th with DJIA at 10,698. But you will pay tax on your gains at your ordinary tax rate. Which is not to say that staying in the market would have made it any better. It is clearly better to take the profits and worry about taxes later.
Or better not at all. Instead of worrying, how about taking some time now to calculate your 2010 tax liability, which can save you a bundle particularly if you booked solid gains. There is certainly nothing to be gained by underestimating your tax payments and on top of that making an estimated tax payment might turn out to be a smart move.
Your capital gains tax rate depends on two key factors: the holding period and the type of investment. The most heavily taxed type of income are short-term capital gains (income from the sale of securities which you held for less than a year). In this case, Uncle Sam makes a killing with an income tax of up to 35%. Your tax rate is much better if you happen to hold onto your investment for a period of more than one year. So getting out of the stock market around the 9th of August (rather than at the end of April) could have been the smartest move for those of us who happened to clock in a year and can thus claim to have made long-term capital gains (LTCG), even if the stock market lost quite a bit. If you are in this situation you can take full advantage of a capital gains tax rate of only 15%, but only if you happen to be in the 25%, 28%, 33% and 35% tax brackets. On paper, capital gain tax rates can be as little as 5%, but that only applies if your income conforms to the 10% and 15% tax brackets.
What this also shows it that there is little to be gained by showing up every day on the (virtual) e-trading floor just because of a misunderstood sense of duty or work ethic. Get rid of your employee or self-employed-person mentality and mind your own bottom line. Indeed, it is much better to focus on getting in when there is still blood on the streets and most of all getting out while the likes of Jim Cramer and Maria Bartiromo want to stubbornly convince you that the ride up will never end.