What's New in Financial Strategies – January 2011

New law sets estate tax rates and exemptions

The 2001 tax law eliminated the estate tax for 2010. The tax was scheduled to return in 2011 with a 55% top rate and an exclusion amount of $1 million. Under the new law, the estate tax is retroactively reinstated for 2010 with a maximum estate tax rate of 35% and an exclusion amount of $5 million ($10 million for married couples). The new rate and exclusion amount will apply through December 31, 2012. Along with these changes, the new law reinstates the step-up in basis for inherited property.

For deaths occurring in 2010, estates have a choice between applying the estate tax with a step-up in basis to fair market value for estate property or no estate tax with a modified carryover of the decedent's basis.

The new law allows a surviving spouse to utilize the unused portion of the deceased spouse's estate tax exclusion amount, providing the surviving spouse with a larger exemption from the estate tax.

Under the new law, the gift tax maximum rate is set at 35%, with an exclusion amount of $5 million, effective through 2012.

Where you hold an investment matters

You'll probably be doing a 2011 review of your investment portfolio for tax and rebalancing purposes. As part of your review, check to be certain you are holding your specific investments in the right type of account. Your goal is to hold investments that produce ordinary taxable income in tax-deferred accounts and to hold those that produce tax-free or tax-favored income in your regular taxable accounts.

Consider this situation. If you hold tax-free municipal bonds in a tax-deferred retirement account, you are "sheltering" interest income from taxes that never would be taxed in the first place. Withdrawals from the retirement account will be taxed as ordinary income at ordinary income rates, and that includes interest from the municipal bonds. The result is that normally tax-exempt earnings eventually become subject to income tax.

Another example: Long-term capital gains are taxed at lower rates than interest income. So investments generating interest might be better held in retirement accounts, while investments generating capital gains might be better held in taxable accounts. Remember, withdrawals from retirement accounts (other than Roth IRAs) are taxed at ordinary income rates even if the income comes from long-term capital gains.

Tax-deferred retirement plans should outperform an investment account that is exposed to annual taxation. But if you're not careful where you hold specific types of investments, you could end up with less rather than more income.

For more information contact our office by phone at 408-879-9990 or by email at cpa@cpasllp.com. You can also visit our website www.cpasllp.com for more details.