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Planning Your Taxes in a Crazy World

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Tax planning is never an easy thing to do. But it's been a very long time since we've seen the kind of uncertainty that taxpayers are now having to deal with. With so many things up in the air, how can you make great investments while making sure that they're also the tax-smart thing to do?

Taxes of all kinds
Much of this uncertainty results from the fact that past tax laws, such as the 2001 tax act, had sunset provisions, giving them an expiration date. Back then, it seemed perfectly reasonable to assume that by the time 2010 or 2011 came around, lawmakers would have made definitive arrangements either to extend those provisions or eliminate them.

Unfortunately, those arrangements really haven't happened at all. Take a look at some of the tax laws that either have already changed or will be changing in the next year or so without further action:

  • Estate tax. Right now, there's no estate tax. But that's not a perfect situation -- because those who inherit assets may have to pay greater capital gains taxes when they sell, thanks to a complicated set of rules that determines the tax basis of assets you inherit.
  • Capital gains. A maximum rate of 15% applies to long-term capital gains, but individuals in the two lowest tax brackets receive a 0% rate. Next year, the maximum is scheduled to climb to 20% for those above the two lowest brackets.
  • Dividends. Similarly, dividends on many stocks now qualify for a 15% maximum tax rate. In 2011, that provision could disappear entirely, returning dividend taxation back to ordinary income tax rates as high as 39.6% -- or higher, as you'll see below.

In addition, we've also started to see proposals for new sorts of taxes, including the following:

  • A proposed "fee" on financial institutions like Citigroup (NYSE: C  ) and JPMorgan Chase (NYSE: JPM  ) that received help from government funding during the financial crisis would raise nearly $10 billion per year in revenue.
  • Closing a loophole that applies to multinationals might have generated billions in additional corporate taxes, but companies like Microsoft (Nasdaq: MSFT  ) argued that it would threaten their competitiveness.
  • Various health-care reform provisions could result in increased payroll taxes, and a Medicare tax on the investment income of higher-income taxpayers could be in the offing.

What to do now
Even with all this uncertainty, one thing seems almost certain: The government is spending more money than in the past, and it'll need to increase its revenue in order to finance that spending. Given the difficulty that the administration is having getting legislation through Congress, the most expedient way to allow those increases to occur would be to let the favorable tax rates expire next year as scheduled. Regardless of whether Congress acts to make exceptions to tax increases on low-bracket taxpayers, many investors will get caught by the restored old rules.

In my view, potential tax changes make tax-favored accounts like IRAs and 401(k) plans even more valuable. Investing in an IRA doesn't just save you money; it's also much simpler, as you don't have to track things like dividends or capital gains for your annual tax return. As such, if you want to own high-yielding dividend stocks -- for instance, Altria (NYSE: MO  ) and Eli Lilly (NYSE: LLY  ) both yield more than 5% right now -- then an IRA is the best place for it.

On the other hand, long-term buy-and-hold investors may not need to worry about tax changes too much. After all, one of the best ways to get rich on long-run winners like Apple (Nasdaq: AAPL  ) and Green Mountain Coffee Roasters (Nasdaq: GMCR  ) was simply to hang onto your shares in a regular taxable account. With no dividends, there's no tax bill along the way -- and until you sell, you won't pay any tax on your paper gains. That's a strategy that's likely to work no matter what happens to tax rates this year or next.

Give it your best
Figuring out how to plan for your taxes is tricky. By recognizing that there's only so much you can do to predict the outcome of the current tax-law morass, you'll leave yourself in a better position to roll with the punches and be ready for whatever comes.

To get help with your taxes, be sure to turn to the Motley Fool's tax collection. You'll find lots of ways to save, and it's absolutely free.

Fool contributor Dan Caplinger is always trying to plan. He owns shares of Altria. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers choice. Apple is a Stock Advisor recommendation. Motley Fool Options has recommended a diagonal call position on Microsoft, which is an Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. Plan better with the Fool's disclosure policy.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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