The Basics of the New Tax Act
On May 17, 2006, President Bush signed into law the Tax Increase Prevention and Reconciliation Act of 2005, or TIPRA for short. TIPRA affects the taxes you pay on dividends and capital gains, the alternative minimum tax (AMT), the "kiddie" tax and Roth IRA conversions. Given all the changes, the new tax law exacerbates the need for you to do your financial planning now rather than later. To get you up to speed, here's a summary of the changes:
Dividends and Capital Gains
The Jobs and Growth Tax Relief Reconciliation Act of 2003 established a maximum tax rate of 15 percent for long-term capital gains and "qualified" dividend income. These rates were scheduled to expire after 2008, but TIPRA extends them through 2010. For taxpayers in the top four tax brackets, this means the tax rate on long-term capital gains and qualified dividends will be 15 percent through December 31, 2010. For taxpayers in the lowest two tax brackets (10 and 15 percent), the capital gains and qualified dividend rates will be five percent through 2007 and zero percent from 2008 through 2010.
In terms of tax planning, TIPRA may make it attractive for wealthier families to give appreciated assets to college-age children who don't work and are in either of the lowest two tax brackets. As long as the gift doesn't exceed $12,000 in 2006 (or $24,000 if a married couple gifts the asset), no gift tax is due on the gift itself or on the appreciation. Consequently, it makes the most sense to gift securities that have growth potential.
TIPRA also creates an opportunity for retirees and other people with low taxable income to wait until years 2008 to 2010 to sell appreciated securities when the capital gains rate drops to zero percent, thereby eliminating a capital gains tax liability.
Alternative Minimum Tax (AMT)
The AMT was created to ensure that all taxpayers pay a minimum amount of taxes. Unfortunately, over the years, more and more middle income taxpayers have been subject to the AMT and have consequently owed additional taxes, because the AMT exemption--the amount of income which isn't subject to additional taxes--isn't indexed to inflation.
These AMT exemption amounts, which were expanded under various tax laws in 2001, 2003 and 2004, expired at the end of 2005. TIPRA increases AMT exemption amounts beyond their 2005 levels for 2006 ly. New AMT exemption amounts for 2006 are:
- $62,550 for married individuals filing jointly
- $42,500 for single filers
- $31,275 for married individuals filing separately
Also in 2006, nonrefundable personal tax credits (the dependent care credit, the credit for the elderly and disabled, the Hope credit for certain college expenses and the Lifetime Learning credit, for instance) can be used to offset the AMT.
In 2005, an estimated four million taxpayers were subject to the AMT, but a recent report from Congressional Research Services estimates that 23 million taxpayers will be subject to the AMT in 2007 unless the tax law changes. TIPRA relief for 2006 is more of a bandaid than anything else. Further efforts to reform or repeal AMT are uncertain due to the costs involved.
The "kiddie" tax refers to the situation where the investment income of a child is taxed at the parents' top marginal income tax rate rather than the child's lower tax rate. TIPRA increases the age of children who are subject to the kiddie tax rules from 14 to 18. Furthermore, the age increase is retroactive to January 1, 2006. Exceptions apply for minor children who are married and file a joint tax return, and distributions from certain qualified disability trusts. The implication of this change is that it prevents parents from shifting any of their investment income to any of their children who are in a lower tax bracket.
While the age increase was implemented to curb asset shifting by the wealthy, it has the unintended consequence of penalizing teenagers who work and save their money and parents who save for college using custodial accounts in their children's names.
Roth IRA Conversions
Currently, in order to convert a traditional IRA to a Roth IRA, a person must have an adjusted gross income (AGI) of less than $100,000. Starting in 2010, TIPRA eliminates this $100,000 AGI limitation.
Additionally, starting in 2010, if you convert a traditional IRA to a Roth IRA, TIPRA provides you with the option of spreading the taxable income over two consecutive years or just one. So you can pay the tax due on the conversion over two years or in one lump-sum in the year you convert it.
This change allows individuals who have traditional IRA balances to weigh the benefits of converting some or all of their balances to a Roth IRA. The potential benefit of Roth IRA conversions occurs when a taxpayer is presently in a lower tax bracket than he or she expects to be in retirement. In this case, you can minimize your tax bill and have more after-tax dollars by converting and paying the tax now vs. later. Though we don't have a crystal ball, if you believe your tax rate will be higher in the future due to your expected income stream or your beliefs about future tax rates, then you should consider this new tax change.
Be sure to consult with your own financial planner to see how the TIPRA changes might affect your own situation.