2009 year-end tax tips

Managing your taxes effectively means looking beyond the taxes you pay today to those you might expect to pay in the future. And the past couple of years have shown us that every dollar of net return really counts. Here are a few simple but effective tax strategies that can have a favorable impact on the net results of your portfolio.

Employ down market strategies

You can sell securities at a loss to reduce and possibly eliminate capital gains taxes.

Here's how it works: When you sell a poor-performing investment, you can subtract your losses from your capital gains for the year and potentially lower your tax liability. In fact, you can deduct up to $3,000 ($1,500 if you're married and filing separately) of the remaining net capital loss from your taxable income this year to offset other income on your return. Then you can carry any remaining capital loss forward into subsequent tax years. But when claiming losses this way, you need to be aware of the wash-sale rule. If you sell stock or a security for a loss, then buy back that stock or security or one that is substantially identical within 30 days before or after the sale, you can't claim the loss for tax purposes.

Consider municipal bonds

Given the generally cautious nature of many investors in the current environment, demand for bonds is expected to remain strong. Municipal bonds can be particularly attractive if you are in the 28% tax bracket or higher. Income on bonds is generally exempt from federal income tax, and bonds issued within your own state can also be exempt from state income tax.

Through municipal bonds, you can diversify your portfolio into fixed-income investments while adding tax diversification to your holdings. Note: Interest from certain municipal bonds may be subject to the alternative minimum tax (AMT) and state and local taxes. Also, sales of these instruments can generate capital gains or losses.

Focus on tax diversification

By building a portfolio that contains a mix of taxable, tax-deferred and tax-free investments, you can gain the flexibility you'll need when it comes time to pay for retirement, college and other critical financial goals. Here's how a combination of investments can provide you with significant tax advantages.

Tax-free income: A variety of investment options allow you to take out your money tax-free or generate tax-free income once you meet certain conditions. These include Roth IRAs, Roth 401(k)s, municipal bonds (see above), cash-value life insurance policies and tax-exempt mutual funds. In addition, Roth IRAs and Roth 401(k)s allow you to grow your money tax-free. Also, 529 plans can provide tax-free money to meet qualified higher education expenses.¹

Tax-deferred income: Traditional IRAs, 401(k)s and 403(b)s provide an upfront tax deduction as well as tax-deferred growth. This also applies to SEP and SIMPLE IRA plans and pension plans. With these types of accounts, you will generally have to pay ordinary income tax when you withdraw taxable earnings. Nonqualified annuities and series EE bonds can also provide tax-deferred growth, but without the upfront tax deduction. These options can benefit those who expect to be in a lower tax bracket after they retire.¹

Taxable income: When compared to the tax benefits of tax-deferred and tax-free accounts, taxable accounts may not seem to offer much. But taxable income from mutual funds, stocks, bonds and bank accounts is essential to a well-rounded portfolio because of its liquidity. Also, qualified dividends are taxed at lower long-term capital gains rates through 2010.

Let's say you face a large one-time expense — a vacation, a child’s wedding or a major home repair. When you withdraw money from a taxable account and sell appreciated property you've held more than a year, the appreciation (if any) will be subject to the long-term capital gains tax, which is currently at a very attractive rate. The money in your taxable income accounts is generally available when you need it without penalty.

You can't predict with any certainty whether you’ll be in a higher or lower tax bracket, if your income will rise or fall, or if your tax rates will increase. That's why it's important to include a mix of tax-free, tax-deferred and taxable investments in your portfolio.

Take advantage of the special Roth IRA conversion opportunity in 2010
Beginning in 2010, everyone can qualify for a Roth IRA conversion, regardless of income or tax-filing status. But the income limits on Roth IRA contributions remain in place.

If you are not eligible for a deductible IRA and your income is too high to fund a Roth IRA, consider making a non-deductible traditional IRA contribution for the 2009 tax year and converting to a Roth IRA in 2010. This will allow your IRA to grow tax-free rather than just tax-deferred. Plus, the money can be withdrawn tax and penalty free, assuming certain holding period requirements and other qualifications are met.

Also, for Roth IRA conversions that occur in 2010, the income tax from the conversion may be paid for the same year or spread equally on your 2011 and 2012 income tax returns. There are special tax rules that apply to this option if you have existing pre-tax money in your IRA, so be sure to talk to your financial and tax advisors before adopting this strategy.

For more information on Roth IRA conversions, read Prepare now for a 2010 Roth IRA conversion and Is a Roth IRA conversion right for you?

Your tax planning checklist

Here's a list of common year-end tax actions:

• Assess gains and losses to minimize taxes
  When the end of the year approaches, it is a good time to assess capital gains and losses, both realized and unrealized, in your investment portfolio. This includes analyzing your portfolio's holdings and divesting poor performers to potentially reduce your tax obligation.

• Rebalance your portfolio
  Rebalancing requires that you take some gains off the table when an investment is performing particularly well, and reinvest those proceeds in an asset class that has been underperforming, but has the potential to perform better in the future. While this may seem counter-intuitive, it can make your portfolio less sensitive to market fluctuations in the long run.

• Identify mutual fund distributions
  A distribution you receive from a mutual fund may be an ordinary dividend, a qualified dividend, a capital gain distribution, an exempt-interest dividend or a non-dividend distribution (sometimes called return of capital). Funds that invest overseas can also distribute a foreign tax credit. The tax treatment for each kind of distribution can vary.

• Save for education
  College savings plans can offer numerous tax advantages. For example, if you invest after-tax money into a 529 plan, it will grow tax-deferred and can be withdrawn tax-free to pay for qualified education expenses. State income tax and other benefits may also be available.

• Make retirement plan contributions
  Because of the tax advantages, try to make the maximum annual contribution to your IRA accounts. Also maximize the amount you invest in your employer-sponsored retirement plan so you can defer income tax on the amount you save, take advantage of any matching contributions and enjoy tax-deferred growth on your account.

• Prepare for RMDs to start up again
  Required minimum distributions (RMDs) from IRAs and other defined contribution plans were suspended in 2009, but will resume in 2010. Make sure you're prepared to start taking the appropriate distribution amounts as required so you can steer clear of hefty IRS penalties and keep more of your hard-earned money.

• Explore charitable giving options
  The greatest benefit of charitable giving is knowing you've helped make a difference. But if you follow the right guidelines, your gift may also provide a tax benefit. Make sure the charity you select qualifies as an organization for which a charitable tax deduction is allowed according to IRS rules.

• Consider gifting strategies
  Annual gifting is one way to reduce the value of your taxable estate. For 2009, the annual gift tax exclusion allows each donor to give up to $13,000 to an unlimited number of individuals without being subject to federal gift tax.

• Accelerate, defer or shift income according to your situation
  If you expect your tax bracket to be higher next year, accelerating your income into 2009 can provide tax savings. On the other hand, deferring your income to 2010 can help reduce your income tax liability this year. Also, to a limited extent, you can shift income to members of your family who are in a lower tax bracket to help reduce your federal income taxes this year. But beware of the "kiddie tax" rules for children under 24.

• Check your federal income tax withholding levels
  You should always check your withholding levels before the end of the year — especially if there are personal or financial changes in your life, or changes in the law that might affect your tax liability. This can help you avoid any surprises when you complete your tax return the following year.

• Calculate any AMT liability
  Based on existing tax laws, certain types of income and expenses are eligible for special deductions and credits. The alternative minimum tax (AMT) attempts to ensure that anyone who benefits from these tax advantages pays at least a minimum amount of tax. If you are subject to AMT, your tax advisor can help you calculate your liability.

• Maximize deductions
  If you itemize, make sure you take advantage of all the deductions for which you qualify. For example, look at union dues and fees for car tabs; or if you have a small business, membership fees for professional organizations and subscriptions to magazines related to your line of work.

• Prepare for tax time
  Even though there is a lot of focus on taxes in the spring, you should plan for it throughout the year and have a year-end checkpoint to confirm your documentation is in order. This includes receipts for charitable donations, energy-efficient home improvements and child-care expenses, as well as any business-related expenses if you are self-employed.

Effective tax management starts with planning ahead. Talk with your financial advisor to find out which tax-advantaged investment strategies are right for you.

¹Tax penalties may apply for early withdrawal.

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