Educated guesswork

The problem: If Congress takes no action by year’s end, multiple Bush-era tax cuts will expire. As such, 2011 will arrive with a variety of tax changes, including higher capital gains rates, new rules on qualified dividends, and increases in certain income taxes. Despite lots of speculation about the impact of the midterm election, the pundits can only guess what the tax landscape will look like in 2011 and beyond.

“I don’t see this election changing the stalemate,’’ says Mark Luscombe, principal tax analyst at CCH, a leading provider of tax information. The lame-duck Congress, he says, may not have either the time or inclination to tackle the topic. “It actually creates the potential for even more stalemate.’’

So, what to do? Given the continuing uncertainty, financial advisers suggest that taxpayers focus on what’s certain, consider what’s likely, and look for planning opportunities designed to protect them no matter what Congress decides. That means taking advantage of tax breaks while they exist and building flexibility into future planning. Here are some things to consider:

Income taxes may rise. With the expiration of the Bush tax cuts, top income tax rates are scheduled to rise, with the current top rate of 35 percent jumping to 39.6 percent in 2011 and the current 33 percent rate increasing to 36 percent. People in these brackets — or those who expect their bracket to rise — may want to take advantage of the current 2010 rate by accelerating income. Those who can, for example, may want to take their bonuses this year or exercise stock options now.

“The course with the least amount of risk is to recognize income in 2010,’’ says Carl Jenkins, managing director at CBIZ Tofias, Cambridge. “The worst that could happen is that you pay the tax sooner.’’

Even those in the lower brackets may end up paying more since the lowest income tax bracket — currently 10 percent — will disappear and be replaced by a 15 percent bracket. The IRS has yet to announce marginal tax brackets for 2011, which makes planning even more difficult.

Capital gains rates could go up. If Congress takes no action, maximum long-term capital gains rates will increase to 20 percent from the current 15 percent rate. That new rate will affect everyone except those in the lowest tax bracket, who will see their capital gains rate jump to 10 percent from zero. As a result, it may be a good idea for people to recognize investment gains in their portfolio, locking in the lower 2010 capital gains rate.

Locking in gains works particularly well for people looking to rebalance and diversify, says Barbara Nevils, a fee-only planner based in Wakefield. “If they have a good gain on an investment and they’ve held it for a couple of years, it might be time to trim it back,’’ she says.

And wash sale rules — which prevent people from claiming a stock loss if they buy replacement shares within 30 days — apply only to losses. That means there’s nothing to keep an investor from realizing a gain and then buying the stock back if it still seems like a good investment.

It may also make sense to harvest losses, since they can be used to offset gains and any excess losses can be used against up to $3,000 of ordinary income. Excess losses can also be carried forward to future years. Before actually selling the losers in your portfolio, however, look ahead to 2011 when higher capital gains rates may make those losses significantly more valuable.

Deductions may be worth more now than later. The phasing out of itemized deductions for high-income earners disappeared in 2010, but will return in full force in 2011. That means upper-bracket taxpayers may want to make tax-deductible donations before year-end. That way they can deduct the full amount donated on their 2010 tax return.

Some may even want to prepay their January mortgage bill as well as state and local taxes, making it possible to deduct both the interest and taxes on this year’s taxes.

But before writing the checks, people should make sure that they don’t fall into the alternative minimum tax category, which would eliminate any benefit from accelerating those payments.

Create tax diversity in your portfolio. One planning approach now gaining currency is tax diversity. “It’s just as important as asset diversity,’’ says Christine Fahlund, a senior financial planner with investment management firm T. Rowe Price. The idea, she says, is to give people greater control of their tax bill by creating accounts that are treated differently by the tax code.

People who have most of their money in tax-deferred individual retirement accounts, for example, will find most withdrawals taxed as ordinary income. But if they have other kinds of accounts, they may be able to withdraw needed money without triggering additional taxes.

For example, withdrawals from regular investment accounts are not taxable events, unless an investment is sold in the process, creating a capital gain. And assets in a Roth account aren’t taxed while in the account or when withdrawn as long as the money taken out is either a previous contribution or a qualified withdrawal. By having all three kinds of accounts, people can choose the most advantageous place to get cash when necessary.

Fahlund says that’s one reason why people who have not yet established Roth accounts should do so for 2010. “You should certainly consider this year an opportunity to get money into a Roth IRA if you don’t have any there yet,’’ she says.

Another way to create Roth funding is to convert money now held in a traditional IRA to a Roth. All of the funds converted would first have to be taxed as ordinary income, which could create a hefty tax bill. But taxpayers this year will have the option of deferring that taxable income and paying the bill with the 2011 and 2012 taxes.

With tax rates expected to rise, however, that may not be a good strategy, says Melissa Labant, tax manager with the American Institute of Certified Public Accountants. “I ran my own numbers and found that it actually made sense for me to report the entire amount in 2010,’’ she says, noting that’s a good example of why taxpayers need to look at their own calculations before making any conversion decision.

Even if you convert without crunching the numbers, you’re not stuck. A person who converts in 2010 has until they file their 2010 taxes to decide how to allocate the resulting taxable income.

Moreover, Roth conversions come with an advantageous “do-over’’ provision, which allows people to unwind a conversion if they change their mind for any reason. The deadline for “re-characterizing’’ a 2010 conversion: anytime before Oct. 17, 2011.