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What the New Tax Law Means for You

In late 2010, President Obama signed into law a broad legislative package that protected Americans at every income level from a multifaceted tax increase that was set to kick in on Jan. 1, 2011. The new Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 goes beyond extending the current income tax structure for two years by including a one-year reduction on Social Security payroll taxes.

The law also provides members with a clearer vision of the tax future, if only for two years. “While it provides a greater level of certainty, it’s relatively short-lived,” says Dan Brouillette, senior vice president for USAA Government and Industry Relations. “As we head into a new Congress and another political campaign cycle, it’s important for members to consider that it could all change in two years—or even sooner.”

With that in mind, here’s a summary of the law’s major provisions and how they may affect your financial planning in 2011 and beyond.

What’s Affected: Income taxes
What You Need to Know: The tax rates in effect in 2010 are extended for the 2011 and 2012 tax years—at all income levels.

What’s Affected: Social Security taxes
What You Need to Know: Working Americans usually pay a 6.2 percent Social Security tax on earnings up to $106,800. In what’s being called a one-year payroll-tax holiday, the rate will be lowered by two percentage points—to 4.2 percent—for 2011 only. Benefits won’t be affected. Self-employed individuals get the same 2 percent break, with their Social Security tax also up to $106,800, lowered from 12.4 percent to 10.4 percent.

What’s Affected: Unemployment insurance
What You Need to Know: Under special measures enacted in response to the economic recession, the unemployed can receive benefits for up to ninety-nine weeks. The new law extends this ninety-nine-week maximum through the end of 2011.

What’s Affected: Capital gains and dividends
What You Need to Know: The 15 percent maximum tax rate that’s applied to long-term capital gains and qualified dividends will continue through 2012.

What’s Affected: Child tax credit
What You Need to Know: The $1,000-per-child credit is extended for two years. As before, the credit will be reduced for taxpayers with $75,000 of adjusted gross income ($110,000 for married couples filing jointly). In a new twist, this credit becomes partially refundable for low-income families. That means some families may qualify for a tax refund even if the credit reduces their tax bill to zero.

What’s Affected: Itemized deductions
What You Need to Know: Before the law, tax deductions for items such as mortgage interest and charitable contributions would have been reduced in 2011 if your income exceeded certain levels. The law prevents that limit from taking effect.

What’s Affected: Estate taxes
What You Need to Know: After a one-year vanishing act in 2010, this tax on the value of a deceased individual’s assets will return in 2011, but with much lower rates than the previous law indicated. Generally, estates valued at less than $5 million will not be subject to the estate tax. Those above that level will be subject to a maximum 35 percent tax rate.

What’s Affected: Coverdell Education savings accounts
What You Need to Know: Through 2012, these accounts will allow tax-free withdrawals for qualified elementary and secondary education expenses—not just college. Contribution limits, which were set to tumble to just $500 per year, will remain at $2,000.

What’s Affected: Education credit
What You Need to Know: Slated to expire in 2011, the American Opportunity Tax Credit is extended for two years. The maximum credit is $2,500 per year and can be used for up to four years of college tuition and related expenses. This break is reduced or eliminated altogether if your adjusted gross income is greater than $80,000 ($160,000 for married couples filing a joint return).

What’s Affected: Teachers’ costs
What You Need to Know: The $250 deduction for out-of-pocket expenses borne by teachers is restored for 2010 and 2011.

What’s Affected: Alternative minimum tax
What You Need to Know: In 2011, exemption amounts are increased to $48,450 for individual taxpayers, to $74,450 for married taxpayers filing jointly and surviving spouses, and to $37,225 for married couples filing separately.

What’s Affected: Business expenses
What You Need to Know: In 2011, businesses may deduct 100 percent of their capital investments—double the 50 percent ceiling in effect before law.

What’s Affected: Charitable giving
What You Need to Know: The law extended the ability for Americans who are seventy-and-a-half years old and older to make tax-free distributions from their IRAs directly to qualified charities up to $100,000 per year through 2011. These distributions also can be used to satisfy required minimum distributions. To enjoy tax-free treatment, the IRA custodian or trustee must distribute or make a check directly to the charity—it can’t pass through your hands. The law also lets you treat charitable distributions made in January 2011 as if they were made in 2010. If you’re planning to do that, be sure to inform your IRA custodian or trustee to ensure the distribution is reported correctly to the IRS.

What’s Affected: Sales tax deduction
What You Need to Know: The law extends the option to deduct state and local sales taxes on Schedule A through 2011. You may deduct these taxes instead of—but not in addition to—state and local income taxes.

What’s Affected: Property tax deduction
What You Need to Know: Not all tax breaks were revived or extended—2009 was the last year you could use the standard deduction and take a limited property-tax deduction for real estate taxes. For 2010 and future years, only those who itemize deductions on Schedule A will be allowed to deduct these taxes.

How to Make It Work for You
After all the commotion, the net result of the tax bill is a little anticlimactic: in 2011, the tax landscape will look much like it did in 2010. But there is one aspect that should have your full attention, and that’s the one-year reduction on Social Security taxes.

“If you’re employed, the payroll tax break immediately puts more money in your pocket on payday,” says USAA certified financial planner practitioner June Walbert. For example, if you earn $60,000 a year, this tax break will save you $1,200 over 2011—or about $100 per month. (Your actual take-home pay may not increase by quite that much, however, because one tax credit was allowed to expire—the Making Work pay credit, which was worth up to $400 a year for individuals with adjusted gross income below $75,000 and $800 for married couples below $150,000.)

Walbert recommends using the extra cash to support your own economic recovery by shoring up your emergency fund, paying down debt, rounding out your insurance or investing for the future.

“The best approach is to get this money out of your monthly cash flow immediately,” says Walbert. “If you don’t redirect it as soon as possible, it may get lost in your everyday spending and you’ll miss out on a great one-time opportunity to improve your financial situation.”

Walbert points to three other notable implications of the tax law:

  • There’s no reason to rush investment gains. “Facing a potential capital gains tax increase in 2011, some people were inclined to rebalance their portfolios by selling investments in 2010 and pay taxes at that year’s rates,” says Walbert. With the rate now staying the same, you can split the rebalance and resulting taxes over two years rather than paying all at once.
  • Now is a good time to revisit your legacy plan. Don’t let the $5 million estate-tax exemption lull you into thinking your estate is protected. You still need to plan ahead because these laws and limits are set to expire at the end of 2012. There is no guarantee that estates valued at less than $5 million will not be subject to the estate tax in the future.
  • Don’t rush to file your 2010 return before the due date. The late changes to the tax code left the IRS scrambling to get ready for filing season. If you’re itemizing deductions on Schedule A, claiming the higher education tuition and fees deduction or deducting educator expenses, the IRS asks that you wait until mid- to late February to file. Learn more.

Visit with your estate planning attorney and financial planner to determine the best strategy considering the possibility of a stricter estate tax structure in 2013, after the current law expires.

“While the new law protects many more families from higher taxes overall, careful planning with your financial advisor can turn a non-event into a financial boon for your family,” adds Walbert.

Originally published on USAA