New Tax Rates Could Create New Opportunities
03/01/2011 - Americans now know that income tax rates are not going up (at the federal level) this year. In fact, most people will temporarily pay less federal tax than was the case previously. The tax savings may create an opportunity for you to consider putting more money to work toward your key financial goals.
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Here is a rundown of what's been put in place effective in 2011 (or in some cases, in 2010):
Extension of 2010 tax rates
Federal income tax rates established in 2001 and scheduled to expire at the end of last year are now in place through 2012. Tax brackets start at 10 percent and peak at 35 percent.
Temporary Employee Payroll Tax Holiday
For 2011 only, the 6.2 percent Social Security tax deducted from your paycheck (up to the first $106,800 of Social Security wages in 2011) will be reduced to 4.2 percent. That means an extra $200 for every $10,000 of Social Security wages you earn (up to the Social Security wage limit). Note that the reduction does not apply to the employer's contribution to Social Security and the payroll tax related to Medicare for both employers and employees remains unchanged. A similar reduction also applies for self-employment tax.
Extension of capital gain and dividend tax rates
Like income tax rates, existing rates on long-term capital gains and qualifying dividends were scheduled to increase at the end of 2010. However, the rates that existed in 2010 have been extended through 2012. The highest applicable tax rate on most long-term capital gains and qualifying dividends is 15 percent and for lower-income taxpayers can be as low as 0 percent.
Renewal of Education Tax Credit and Other Education-Related Provisions
The enhancements made to the Hope Scholarship Credit (American Opportunity Tax Credit), which provided for a $2,500 maximum tax credit per student for the cost of tuition and related expenses paid during a taxable year in 2009 and 2010, is extended to 2011 and 2012. Qualification for the credit is subject to income limits. The credit is phased out for single taxpayers with income over $80,000 and married couples filing a joint return with income over $160,000.
Also extended for 2011 and 2012 is the ability of certain individuals to deduct up to $2,500 in interest on qualified higher education loans from their income taxes. The deduction phases out for individuals earning more than $60,000 and married couples filing a joint return with income above $120,000.
Families can continue to invest up to $2,000 per year in Coverdell Education Savings Accounts in 2011 and 2012. Dollars can grow on a tax-advantaged basis and be used to pay elementary, secondary and higher education expenses.
Estate Tax Is Back But Affects Fewer People
The estate tax has been in flux for several years. In 2009, a per-person exclusion of $3.5 million was in place. Taxable estates valued beyond that amount were subject to a tax of 45 percent. In 2010, the estate tax was scheduled to be repealed, but only for that year. Under the new law, the estate tax is retroactively reinstated for 2010 (but with an elect-out provision) with an exclusion amount set at $5 million per person, so potentially $10 million per couple – with a tax rate of 35 percent applying to estates larger than that. The higher exclusion amount and lower rate apply for 2011 and 2012.
What to Consider Now That Rates Are Set
Strategies that may be suitable will depend on your circumstances, but here are some specific ideas to consider in light of the recent tax legislation:
• Make sure that the amount being withheld from your paycheck is appropriate. Now that you know income tax rates aren't going up this year or next, you are better off avoiding having too much withheld and ending up with a large tax refund every year. This is money that could be put to better use each month, specifically toward your key financial goals.
• Consider taking the two percent savings from the temporary payroll tax holiday and putting it to work toward your retirement by increasing the amount directed to your workplace savings plan, or making a regular contribution to an IRA.
• Determine if you should adjust your investment strategies to take advantage of the ongoing favorable rates for long-term capital gains and qualifying dividends.
• Review your estate plan to determine if any changes are needed in light of the new estate tax laws. Make sure any trusts and wills are up to date and consistent with the law, especially since the most recent change is only effective through 2012.
• Stay prepared for future changes. By the end of 2012 at the latest, Congress is likely to have to address many of these same tax issues again. A regular review of your financial and tax situation should be part of your routine.
• Consult with your financial and tax advisors for more information before making any critical decisions that could have a tax impact.
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