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How To Play The Changing Tax Picture in 2010

What goes down, must come up.

That's the physics of taxes right now.

A decade of tax cuts is coming to an end in 2010 and though details on tax hikes are few at this point, the writing is certainly on the wall.

Here's some investment strategies that will help ease the pain.

Estate Tax

First the good news—and a one-year wonder. There is currently no estate tax.

Now the bad news. If Congress does nothing, we will return to the pre 2002 law—a $1 million estate tax exemption and a graduated maximum rate of 50 percent on additional income. How bad is that? Well, by comparison, in 2009, each individual could shelter $3.5 million worth of assets and the top tax rate was 45 percent.

Though only those on their death bed will be able to fully exploit this unprecedented tax hole, the healthy have some options.

“If you currently have assets that have decreased in value, but you anticipate that they will come back, those assets might be ripe for gifting to get them out of your estate,” says Brian Raftery, partner in the Trusts & Estates group at Herrick Feinstein in New York.

It is also a good time to gift assets to your children or to trusts for your children.

“Right now real estate, certain stocks are at historic lows if you can give them away now and get them out of your estate, then they are not part of your estate as the economy comes back and as they increase in value,” says Raftery.

For example, if someone owns land in Florida that is worth $100,000 today, but in 2006 it was worth half a million, giving it away might be a better move than holding it until it goes back up to half a million. The value at the time of death would be part of the taxable estate.

Normally, there is also something called a Generation Skipping Transfer Tax, GST. This applies to money that someone might leave to a grandchild to circumvent taxes that would be applicable if the money had instead gone to a son or daughter.

Under current law, there is no GST, so 2010 is the time for people to set up and fund trusts that will last for the lifetime of a child, grandchild or great grandchildren. These are often called dynasty trusts.

That's about as good as it gets. Two-thousand and eleven will bring higher taxes in three key areas—income, capital gains and dividends.

Though all six of the income-tax brackets are scheduled to rise with the expiration of the Bush tax cuts of a decade ago, the Obama administration is expected to reserve the increase to only the two highest brackets. So the 32-percent and 35-percent brackets will become 36 percent and 39.5 percent, respectively.

The long-term, capital-gains tax will rise from 15 percent to 20 percent. The tax on dividends will rise from 5 percent or 15 percent (depending on your income) to a maximum of 39.6 percent, because it will be treated as ordinary income.

Municipal Bonds

Given that scenario, more investors than usual may be tempted to look at municipal bonds, which are largely exempt of state and federal taxes.

Barbara Lane, partner at Citrin, Cooperman & Company in White Plains, New York, says before investing in municipals, investors should look at what the effective rate or the rate after taxes if you invested in something taxable; your net might still be higher with a taxable investment.

“You have to see what kind of rates you can get on both sides and what kind of tax bracket you are in,” she says.

High-grade municipal bonds returned between 11.5 percent and 13 percent in 2009, as the economy shrank and interest rates fell; few expect the same kind of performance even with the current Treasury market rally.

Investors also need to know that unlike Treasurys or government-insured deposit bank products like CDs or money market funds, there is a default risk with municipal—or state—bonds.

The two main varieties are general obligation bonds, which are secured by a government pledge to use resources such as tax revenues to repay investors—and essential service revenue bonds as good examples, which cover things such as water and sewer systems and projects.

The bottom line: if you're buying them for yield and are willing to hold them to maturity, then many financial advisors think that municipal bonds are a great place to be in light of anticipated higher income taxes.

Education & Health

Another way to offload some income is to make a five-year, tax-free contribution to a 529 college savings plan. You essentially piggy back on the annual gift tax exclusion, which for this year is $13,000, and take five years worth in one tax year. You don't even need to file a gift tax return.

Raftery says 529s look even better when tax rates are on the way up—all of the income and capital gains earned within the the plan grow tax free, as long as the proceeds are ultimately used for educational expenses.

“So if I keep my $65,000 in my bank account and I’m earning interest on it, I pay tax on the interest that the $65,000 earns," says Raftey. "If I put it into a 529 plan, there is no income tax on the assets in the 529 plan, and if the income taxes I have to pay are going up, hey, the tax free investment of the 529 plan looks even better,” he says.

For many taxpayers, 2011 will be just the beginning. Starting in 2013, more new taxes will be introduced to help pay for the health care reform law. Investment income and capital gains will likely be subject to an extra tax, say experts, so those who can might want to cash in on extra income in 2012.

Change aside, experts say investors should not forget about tried-and true-tax planning strategies of the past.

Steve Wallman, founder and CEO of Folio Investing in McLean, Vir., recommends that everyone should look at their investments with an eye to hold on to good performers and offload losers to strategically harvest tax losses.

Lane agrees, adding that no matter what you do for tax-planning purposes, it should also be a good investment decision.

“Never do anything just for taxes,” she says.