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Tax Planning

Trim Your Tax Tab and Pocket Extra Cash

Retirees can take these steps to minimize their 2010 tax bill.

EDITOR'S NOTE: This article was originally published in the February 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

Whew! You're probably much relieved that your tax rates won't rise for the next two years. But before you relax, it's time to look backward a bit -- to the 2010 tax year.

The Tax Relief Act, passed in a last-minute scramble on Capitol Hill, will have little impact on your 2010 tax return. A couple of exceptions: Congress revived the chance for some taxpayers to deduct state and local sales taxes, and it gave the okay to older taxpayers to transfer money from their IRAs to charity in 2010.

For the most part, though, the tax deal looks to the future. It includes a two-year extension of the 15% top rate on long-term capital gains and qualified dividends. It also keeps the Bush tax-cut rates, which top out at 35%, rather than bringing back the 36% and 39.6% brackets.

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For now, you need to focus on trimming your 2010 tax bill. If you paid the alternative minimum tax on your 2009 return and your financial situation remained the same in 2010, you'll probably pay it again. On the bright side, if you avoided the AMT trap last year, you're probably safe again.

Itemize or take the standard deduction? Even if you've been a lifelong itemizer, it could be time to stop. If you're no longer paying interest on a mortgage and you don't have big deductions, why hassle with itemizing if it winds up costing you money? And remember, if you're 65 and older, your standard deduction is higher.

For 2010, the standard deduction for single filers is $5,700. Married couples filing a joint return get a no-questions-asked write-off of $11,400, while heads of households can claim $8,400. Married couples 65 and older get an extra $1,100 each; that means that if both spouses are 65, the couple can get a standard deduction of $13,600. And older singles can add an extra $1,400 to the basic standard deduction amount.

Unlike 2009, homeowners who don't itemize can no longer add up to $500 ($1,000 for couples) to their standard deduction for property taxes. But if you're a teacher or teacher's aide, you can take an above-the-line deduction of up to $250 for out-of-pocket expenses for classroom supplies.

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If you're accustomed to taking a standard deduction, itemizing could make sense if your circumstances have changed, says Bob Scharin, senior tax analyst with Thomson Reuters, a publisher of business information. For instance, if your spouse died in 2009, it may pay to itemize rather than take the smaller standard deduction for singles. (If your spouse died in 2010, you get the full deduction for joint returns.)

Or perhaps your income has declined while your medical expenses have increased. Medical expenses that exceed 7.5% of AGI are deductible. "A person who just retired and is younger than 65 may have to pay full health-care premiums for the first time," says Scharin. Increased premiums, along with a big medical bill or two, could boost you above the threshold.

Scharin also reminds taxpayers to deduct state and local income tax paid when they filed their 2009 returns in 2010. Add that amount to any state and local taxes withheld from paychecks or retirement payouts they received or paid as estimated taxes.

High-income itemizers, take note: For 2010 and for the next two years, there's no "haircut" for your deductions for mortgage interest, charitable gifts, state and local taxes, and tax-preparation fees. In past years, higher-income individuals -- married couples earning $169,550 or more -- could lose a part of their itemized deductions. The restriction was repealed for 2010, but was scheduled to return in 2011. Congress extended the repeal through 2012.

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Make the most of losses. Remember those investment losses in 2008? Sure, those were grim days, but there is a silver lining if you have carryover capital losses to trim your 2010 tax tab.

Such losses first offset any net gains from 2010 sales, and then you can deduct $3,000 of net capital losses against any type of income. Say you carried over $40,000 in net losses in 2008 and used $10,000 to offset 2009 gains and another $3,000 to offset other income. That leaves you with a $27,000 carryover loss. If you use $15,000 to offset 2010 gains, you can use $3,000 more to offset other income. You'll still have $9,000 to carry forward to save you money next year.

Also, remember that if you fall in the 10% or 15% tax bracket (with taxable 2010 income of less than $34,000 on a single return or $68,000 on a joint return), the tax rate on long-term gains is a sweet 0%. That rate applies only to gains that fall within the 10% and 15% brackets. Let's say you're married and would have closed the year with $50,000 in taxable income except that you sold stock for a $35,000 gain. The first $18,000 of that gain (which takes you to the top of the 15% bracket) would be tax-free. The $17,000 balance would be hit with a 15% capital-gains tax.

The 0% capital-gains rate was set to expire at the end of 2010. The Tax Relief Act extended the 0% rate through 2012. Looking ahead, this can be a great deal for retirees living off of their investments. They can sell some long-time assets and pay 0% on at least part of the gains.

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Also, "if an adult child is in a higher bracket, the child can give appreciated securities to a parent who may be in the 15% bracket," says Mark Luscombe, principal federal tax analyst for CCH, a publisher of tax information. The parent can then sell the stock without a tax hit.

Max out retirement contributions. You still have time to lower your tax bill and boost your savings by contributing to a tax-deductible IRA. You have until April 18 to contribute up to $5,000 to a traditional IRA for 2010 plus an extra $1,000 contribution if you're 50 or older. Trim your tax bill even more by contributing up to $6,000 to a spousal IRA. (Starting in the year you turn 70 1/2, you are forbidden to contribute to a traditional IRA.)

If you're covered by a retirement plan at work, you can deduct some or all of your contribution if you are single and your modified adjusted gross income is $66,000 or less (married filing jointly, $109,000 or less). If you're not covered by a workplace plan but your spouse is, you can deduct some or all of your IRA contribution if your joint income is $177,000 or less.

You also have until April 18 to make contributions of up to $6,000 to a Roth IRA for 2010. However, because contributions to a Roth are made with after-tax money, you can't take a deduction. There is no age limit for Roth contributions, but you can't add to a Roth if your adjusted gross income is above $120,000 if you're single or above $177,000 for joint filers.

April 18 is also the deadline for funding a health-savings account if you are covered by an HSA-compatible high-deductible health-insurance policy. For the 2010 tax year, the contribution limit is $3,050 for an individual and $6,150 for a family. You and your spouse can each add $1,000 if you’re 55 and older. Starting in 2011, you can't use your HSA to pay for over-the-counter drugs. You cannot contribute to an HSA after you enroll in Medicare.

Workers who are looking for extra cash to stash in their traditional IRAs or HSAs could consider diverting some of the savings from the one-year cut in the Social Security payroll tax. The Tax Relief Act reduces the employee share of the Social Security tax by two percentage points. Self-employed individuals will pay 13.3% in payroll taxes, down from 15.3%.

Workers who don't pay into the Social Security program, such as some public employees, will not benefit from the cut. Nor will retirees who don't work.

Taxpayers earning at or above $106,800 will get a $2,136 tax benefit in 2011. Employers have until March 31 to adjust their payroll systems, but will boost paychecks to make up for any taxes workers paid in January and February. If you're not sure how much your checks will rise, you can use Kiplinger's online calculator to find out.

Sales versus income tax. The popular tax break that allows taxpayers to choose between deducting state and local income tax or state and local sales tax was set to expire at the end of 2009. But Congress revived it retroactively to cover 2010 and 2011.

Writing off sales tax makes sense primarily for those who live in states with no income tax, such as Florida and Texas. For most residents of income-tax states, the income tax is a bigger burden than the sales tax. But a large purchase could push you into the sales-tax column.

Plus, says Scharin, many retirees have income that is not subject to state income tax, such as Treasury bond interest or disability payments. "Various states have exclusions for retirement income," he says. For example, Illinois, Mississippi and Pennsylvania exempt all retirement income, such as IRA withdrawals and pension payments, from state income tax. These breaks could bring your total for state income tax down below your sales-tax figure.

Kathy Pickering, executive director of the Tax Institute at H&R Block, says you can use the IRS tables that show how much residents of various states can deduct in sales tax. "You can then add any large purchases, such as a car, RV or a boat," she says. Or you can use the IRS Sales Tax Deduction Calculator to help you figure the deduction.

Paying the Roth bill. If you converted to a Roth IRA in 2010, you have a choice. For the 2010 tax year only, you can pay the entire tax tab on your 2010 return, or you can defer payment and split the income in half on your 2011 and 2012 returns.

When it looked like tax rates were going to rise in 2011, many experts were recommending that high-income converters pay the tax in 2010 to lock in the lower rate. Now it may make sense to spread the tax bill, especially if recognizing all the income in 2010 will push you into a higher bracket. If you intend to do more conversions in 2011 and 2012, however, paying the tax on your 2010 return may be a better move, says James Lange, author of The Roth Revolution: Pay Taxes Once and Never Again (Morgan James, $20).

You can reverse the 2010 Roth conversion by October 17 if you change your mind, which you might if the investments drop in value. Undoing the conversion would mean you don't have to pay tax on money that has disappeared.

Bits and pieces. IRA holders who were watching the clock know that Congress extended the popular break that allows taxpayers 70 and older to transfer up to $100,000 directly from an IRA to charity. Lawmakers also agreed to allow charitable transfers that were made in January to be treated as a 2010 donation. (Direct donation will be allowed for 2011, too, but the deadline will be December 31.)

If you made a transfer from your IRA to charity in January, treat it as a 2011 charitable donation rather than a 2010 gift, says Mike Martin, a tax adviser in Independence, Mo. That way, you can satisfy part of your IRA required minimum distribution for 2011.

Homeowners who made energy-saving improvements can claim a tax credit equal to 30% of the cost, up to a lifetime maximum of $1,500. This limit applies to both 2009 and 2010 combined. "Perhaps you put in windows one year and put in a new furnace the next year," says H&R Block's Pickering. The credit applies to biomass fuel stoves, qualifying skylights, windows and outside doors, and high-efficiency furnaces, water heaters and central air conditioners.

For 2011, this credit is not as generous -- a 10% credit up to $500, with no more than $200 for replacement windows. Plus, says Pickering, you're not eligible for the $500 credit in the future if you've already taken the $1,500 credit in 2009 and 2010.

The IRS is scrutinizing all claims for first-time home buyers and longtime homeowners who claimed the home-buyer credit. First-time home buyers must attach a copy of their settlement statement to the return, and longtime homeowners should also attach documents showing prior ownership of a home, including records of property tax and insurance coverage.

Older adults who returned to college or vocational school to improve their job prospects or to just learn something new can qualify for the American Opportunity tax credit. The full credit of $2,500 starts phasing out for individuals with incomes of up to $80,000 and for married couples with joint incomes of up to $160,000. The Tax Relief Act extends the credit for 2011 and 2012.