Year-End Tax Planning Tips for Seniors

Uncertainty about future tax rates and estate rules dominates this year’s tax planning efforts.

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With less than six weeks left before the end of the year, it's time to get serious about planning decisions that will affect your tax returns for 2011. U.S. News interviewed tax professionals and put together a list of major considerations for older taxpayers.

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Experts agree that for wealthy taxpayers, taking advantage of unusually generous estate tax exclusions tops the planning agenda. For 2011, the first $5 million of estate assets are exempt from taxes. This total effectively doubles to $10 million for a married couple. Because of a special "portability" rule, the first spouse to die can elect to transfer any unused estate tax exclusion to the surviving spouse.

Of course, no one is suggesting that wealthy people should plan on dying this year or next. However, that $5 million exemption is also linked to gift taxes on charitable contributions and other gifts, where planning efforts can be employed.

These rules are scheduled to be in place in 2012, along with an inflation adjustment that raises the unified estate and gift exemption to $5.12 million. However, there is a widespread expectation that Congress will reduce the 2012 exemptions in its efforts to cut federal deficits. While that is hardly certain, it has caused some advisers to recommend that wealthy taxpayers step up their charitable contributions this year.

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Under present laws, the $5 million exemption would decline to only $1 million in 2013, and spousal portability would end as well. The tax rate on estate assets in excess of the exclusion amounts would rise to 55 percent from 35 percent.

Another special tax benefit that only applies to 2011 permits owners of retirement accounts who are more than 70½ years old to donate up to $100,000 from these accounts to charities and escape taxation. Normally, the proceeds from the sale of such tax-deferred investments would be taxed as ordinary income before they could be donated to a charity during the life of the donor. Or, the retirement account assets could escape taxation if they are given to a charity in the donor's will.

During a recent webcast by Vanguard about year-end tax planning, charitable giving was one of the major decisions investors are considering. The other two decisions that many named were adjusting the asset-allocation balance in their accounts and thinking about "harvesting" their accounts to take advantage of tax losses before the end of the year. While encouraging people to consider these moves, Vanguard experts speaking on the webcast emphasized that fundamental investment and retirement objectives nearly always trumped tax considerations as the strongest driver of portfolio management decisions.

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Roth IRAs also continue to be a candidate for year-end planning, since rules for creating Roths were made much more attractive in 2010. Unlike tax-deferred IRAs, Roth IRAs permit people to invest funds that have already been taxed, but exempt future earnings on those funds from being taxed so long as the owner's Roth accounts have existed for at least five years and the funds are withdrawn after the owner is at least 59½ years old.

Income limits on taxpayers converting other retirement accounts into Roths were dropped entirely in 2010. Any gains on holdings in such accounts that normally would have been taxed as ordinary income face taxation before they can be shifted into a Roth. As part of the 2010 changes, taxpayers were given the choice of paying all taxes due in 2010 or splitting their tax liability and paying each half on their tax returns for 2011 and 2012. Any taxes on Roth conversions this year are due in their entirety with 2011 returns.

There still are income limits on annual contributions to a Roth IRA. According to Mark Luscombe, the principal federal tax analyst at CCH, total contributions to all IRAs—Roths and regular IRAs—are limited to $5,000 a year, with another $1,000 for anyone past the age of 50. For Roths, these amounts begin phasing out for taxpayers with adjusted gross incomes of $107,000 for single taxpayers, and no contributions are permitted when incomes hit $122,000. For married taxpayers filing a joint return, the phase-out income range is $169,000 to $179,000.

However, Luscombe says, there is a huge loophole high-income taxpayers can use: Just contribute to a normal IRA, which has no income test, then convert the account to a Roth. "As far as I know," he says, such a conversion could literally take place the day after the traditional IRA was set up.

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Experts at TurboTax, which provides tax software, provided a year-end tax checklist for older taxpayers. You may need professional tax advice for some items. AARP operates a free tax-return assistance program for older taxpayers, but it does not begin operations each year until January.

1. See if you qualify for tax credits under programs for certain elderly or disabled taxpayers.

2. Check the tax treatment of Social Security benefits.

3. If your child, or a friend under some conditions, provides at least half of your financial support, he or she may be able to get a tax benefit by claiming you as a dependent on their tax return. Your income cannot exceed $3,700 to qualify for this deduction.

4. Check any 1099-R forms you receive for income from your various retirement accounts and make sure you take advantage of any income that is not taxable on your return.

5. If you can afford to, avoid early distributions from your retirement plan. They can hit you with higher taxes, although there are hardship exemptions for such withdrawals.

6. If you're 70½, make sure you don't forget to take your required minimum distributions (RMDs) from any tax-deferred retirement plans. Failure to take RMDs can trigger a 50 percent tax on the amounts that should have been withdrawn.

7. Don't forget that extra $1,000 contribution that taxpayers may make to their IRAs on top of the normal annual maximum of $5,000. For the 2011 tax year, IRA contributions may be made until April 17, 2012.

Twitter: @PhilMoeller