Tax Tip for
Summer 2006
Tax Increase
Prevention and Reconciliation Act of 2006
President Bush signed a
new tax law in May that contains good news for investors, as well as an
assortment of other changes that spell relief for some taxpayers and financial
pain for others. Here is a summary of the highlights of the provisions in the
Tax Increase Prevention and Reconciliation Act,
which pertain to individuals and small
businesses.
Investor tax
breaks extended.
In 2003, Congress passed
a measure to lower the tax rate on most dividends to 15 percent from as high as
38.6 percent and to lower rates on most capital gains from 20 percent to 15
percent. That measure was set to expire at the end of 2008, but the new law
extends the favorable rates through 2010.
Section 179 Deduction
Rules for Businesses Extended
The tax law currently
allows many small businesses to claim first-year depreciation write-off for the
full cost of most equipment and software additions. This is thanks to the
"Section 179 deduction," which is a longtime favorite of small business owners.
For tax years beginning in 2006, the maximum Section 179 deduction is a generous
$108,000 (the amount is adjusted annually for inflation). However, the Section
179 write-off was scheduled to decrease to a mere $25,000 for tax years
beginning in 2008. The new law extends all aspects of the current favorable
Section 179 deduction rules (including annual inflation adjustments) by two
years — through tax years beginning in 2009. For tax years beginning in 2010,
the $25,000 limitation will kick in unless Congress takes further action.
No Income Limit for
Roth Conversions — But Not for Awhile
In a regular individual
retirement account (IRA), the taxpayer gets a deduction for dollars he puts in
and his earnings grow tax free, but he pays ordinary income tax on every dollar
he takes out, and withdrawals are subject to significant restrictions. In a Roth
IRA, the taxpayer gets no tax deduction for contributions, but his money grows
tax free and there's no tax, and few restrictions, on withdrawals.
Under current law, only
taxpayers with $100,000 or less in modified adjusted gross income can convert a
regular IRA into a Roth IRA. A taxpayer making the conversion generally must pay
tax on money he takes out of his regular IRA, but once it's in his Roth IRA, he
won't pay tax on that money or the money it earns. Generally speaking, Roth
conversions appeal to taxpayers who either think their tax rate will go up in
retirement, or believe that the value of their account will rise significantly,
and thus are willing to make an upfront tax payment when they convert in order
to reap large tax savings in later years.
Under the new law,
beginning in 2010, taxpayers with more than $100,000 of modified adjusted gross
income also will be able to convert a regular IRA into a Roth IRA. To make such
conversions more attractive in 2010, the new law permits taxpayers who convert
in 2010 to spread the income and resulting tax payments on the converted funds
over two years—2011 and 2012.
“Kiddie Tax”
age limit raised from under 14 to under 18.
At one time, wealthy
parents could significantly lower their family's tax bill by transferring
investment assets to minor children. This tax technique, called income shifting,
worked by taking income out of the parents' higher tax bracket and placing it in
the lower tax brackets of their children. To curtail the use of this tax
technique, Congress enacted the “kiddie tax” rules, which said that children
under 14 who had more than a small amount of unearned (investment) income had to
pay tax at their parents' marginal tax rate (the rate of tax on the last dollar
earned).
Under the new law, the
age limit below which a child's income from investments is taxed at the parents'
rates is raised from 14 to 18. The new provisions apply to tax years beginning
after Dec. 31, 2005.
AMT Band-Aid
Applied for This Year
Originally enacted to
make sure that wealthy Americans did not escape paying taxes, the AMT, which is
a parallel tax system which does not permit several of the deductions
permissible under the regular tax system, such as state, local and property
taxes, has started to ensnare more middle-income taxpayers. This is in part due
to the fact that the AMT parameters are not indexed for inflation. In recent
years, Congress has provided a measure of relief from the AMT by raising the AMT
“exemption amounts”—allowances that reduce the amount of alternative minimum
taxable income, reducing or eliminating AMT liability. (However, these exemption
amounts are phased out for taxpayers whose alternative minimum taxable income [AMTI]
exceeds specified amounts.) For 2005, the AMT exemption amounts were $58,000 for
married couples filing jointly and surviving spouses; $40,250 for single
taxpayers; and $29,000 for marrieds filing separately. However, for 2006, those
amounts were scheduled to fall back to the amounts that applied in 2000:
$45,000, $33,750, and $22,500, respectively. This would have brought millions of
additional middle-income Americans under the AMT system, resulting in higher
federal tax bills for many of them, along with higher compliance costs
associated with filling out and filing the complicated AMT tax form.
To prevent the
unintended result of having millions of middle-income taxpayers fall prey to the
AMT, Congress has once again relied on a temporary fix to the problem, this time
a one-year extension of the 2005 AMT exemption amounts, increased slightly.
Under the new law, for tax years beginning in 2006, the AMT exemption amounts
are increased to: (1) $62,550 in the case of married individuals filing a joint
return and surviving spouses; (2) $42,500 in the case of unmarried individuals
other than surviving spouses; and (3) $31,275 in the case of married individuals
filing a separate return.
Another provision in the
new law provides AMT relief for personal tax credits. The tax liability
limitation rules generally provide that certain nonrefundable personal credits
(including dependent care, elderly and disabled, Hope Scholarship and Lifetime
Learning, and the D.C. homebuyer) are allowed only to the extent that a taxpayer
has regular income tax liability in excess of the tentative minimum tax, which
has the effect of disallowing these credits against AMT. Temporary provisions
had been enacted which permitted these credits to offset the entire regular and
AMT liability through the end of 2005. The new law extends this temporary
provision to tax years beginning in 2006.
Please keep in mind that the above describes only
the highlights of the new law. If you would like more details on any aspect of
this legislation, please call us at your earliest convenience.
