To Our Clients and Friends:
Now that April 15th is behind us, it is time to turn your attention to tax planning for 2006. Effective tax planning takes place throughout the year and summer is always a good time to review your tax planning options. In this newsletter we will cover some of the significant provisions included in the new tax law called the Tax Increase Prevention and Reconciliation Act (TIPRA). President Bush signed the new tax law on May 17, 2006. Additionally, we will cover several tax planning opportunities and information on the alternative minimum tax.
Tax Increase Prevention and Reconciliation Act
The Tax Increase Prevention and Reconciliation Act was signed into law in May 2006. The paragraphs below cover some of the major extensions and changes included in the Act.
Popular Extensions
The Tax Increase Prevention Act extends two very favorable provisions for you: the lower
capital gains tax rates and the increased Section 179 expensing election.
The 5% and 15% capital gains tax rates for individuals have been extended two years, through
tax years beginning before January 1, 2011. The 5% rate applies to our clients and their
children in the 10% and 15% tax brackets, (those whose taxable income is less than $30,650 for
2006) while the 15% rate applies to all other higher income tax brackets. For tax years
beginning after 2007, the 5% rate on capital gains will be lowered to zero for the 10% and 15%
tax brackets.
The ability to immediately expense capital improvements and equipment purchases as
provided in Code Section 179 was set to decrease to the amount of $25,000 for tax years
beginning after 2007. The Act extends the higher inflation adjusted $100,000 threshold
amount for two years to tax years beginning before 2010. For tax years beginning in 2006,
the $100,000 amount, after the adjustment for inflation, is $108,000. Therefore all businesses
in 2006 will be able to expense $108,000 of asset additions of equipment and furniture.
New Rules for Roth IRA Conversions
Roth IRA’s can be more advantageous than traditional IRA’s for many of our clients. Roth
IRA contributions are included in income, but any earnings and qualified distributions are
income tax free. However, married couples may not claim a Roth IRA contribution if their
adjusted gross income exceeds $160,000. This leaves many of you without the option to
contribute to a Roth IRA. In addition, before the Act, only individuals with a modified
Adjusted Gross Income (AGI) less than $100,000 could rollover amounts from a traditional IRA
to a Roth IRA while avoiding a 10% penalty on early withdrawals.
The Act provides that for tax years beginning after 2009, the adjusted gross income limitation
is eliminated allowing anyone to convert a traditional IRA to a Roth IRA and avoid the 10%
early withdrawal penalty. Although the taxable portion of the conversion will need to be
included in your income in the year of the conversion, any additional earnings accumulate
tax-free. For conversions that occur in the year 2010 only, the new law allows for a 2-year
deferral period for the conversion income to be reported during the years 2011 and 2012.
This provision effectively eliminates the AGI limitation on Roth IRA contributions for all of
you, since amounts in a qualified retirement plan may be rolled over to an IRA and then into
a Roth IRA beginning in 2010.
Increased “Kiddie Tax”
Beginning in 2006 (this year), the so called “kiddie tax” on unearned income over $1,700 (2006 amount) will affect significantly more of you. The kiddie tax taxes your child’s unearned income over $1,700 at your highest marginal tax rate instead of at your child’s lower tax rate. The Act increased the age to which these tax rules apply from under age 14 to under age 18.
This change will make it more difficult to lower your family’s tax burden by shifting income-producing assets to your children. This does not completely eliminate family tax-planning opportunities, but consideration should be given to transferring assets to your children that are not currently income producing (assets that are expected to appreciate such as land or non-dividend paying growth stocks) or that are tax free or tax-advantaged in nature (municipal bonds or IRA’s).
Interest Reporting Requirements
Previously, tax-exempt interest was not subject to the same reporting requirements as taxable interest. Under the provisions of the Act, any payment of taxable or tax-exempt interest over $10 is required to be reported on a Form 1099-INT and Form 1096. The most significant impact for most of you will be the receipt of 1099-INT’s for tax-exempt as well as taxable interest in 2006. This may affect some of your tax returns since certain types of tax-exempt interest are taxable for alternative minimum tax purposes.
Alternative Minimum Tax (AMT)
Over the past several years the number of our clients subject to the alternative minimum tax has increased dramatically. Many of you may not understand what the alternative minimum tax is or how is it calculated. This can be especially frustrating when you have to pay the additional tax without knowing what caused it.
Originally, AMT was created so that high-income individuals and corporations could not avoid paying income taxes through using certain deductions, exemptions, losses, and credits. The calculation of AMT is basically a separate computation of taxable income and tax.
The calculation of the alternative minimum tax starts with your regular taxable income. Twenty-six specific adjustments are added to or subtracted from regular taxable income to calculate your alternative minimum taxable income. An alternative minimum tax is calculated based on alternative minimum taxable income. If your alternative minimum tax is lower than your regular tax, you will not pay AMT. If your alternative minimum tax is higher than your regular tax, you will pay AMT for the difference between your regular tax and your alternative minimum tax.
Tax planning for the alternative minimum tax can be achieved through knowing some of the more commonly occurring adjustments to regular taxable income. The following are some of the most common adjustments:
Medical and dental deductions from Schedule A (added to taxable income)
Taxes paid from Schedule A (added to taxable income)
Tax refunds received (subtracted from taxable income)
Interest on certain private activity bonds (added to taxable income)
Difference between regular and AMT depreciation (added or subtracted)
Knowing these adjustments aids in AMT tax planning. For example, interest on private activity bonds, exempt for regular tax purposes, is added back for AMT. You may consider switching investments from private activity bonds to municipal bonds. Or, if you expect to have a large medical deduction for the current year, consider paying your fourth quarter state estimate the following year. Conversely, if you received a large state refund the previous year, it will reduce or eliminate the effect of paying your fourth quarter state estimate in the current year. As the previous list is not all-inclusive, please do not hesitate to contact us if you have any questions regarding AMT planning.
Solid Tax Planning Practices
Finally, although the following tax planning practices are not necessarily new, they are solid tax planning practices that many of you would benefit from implementing.
Health Savings Accounts or HSA’s can be a great way to fund your current as well as your long-term health expenditures. These plans are available to you if you have qualified high deductible health insurance. Contributions are pre-tax up to the lesser of the annual deductible for your insurance or $2,700 for self-coverage or $5,450 for family coverage for 2006. Earnings within the plan are not taxed, and distributions for qualified medical expenses are not included in income. If you already have an HSA established, make sure to fully fund it each year.
Fully fund your retirement plan. The IRA contribution limit is $4,000 for 2006, while the 401(k), 403(b), SEP, and Sec. 457 contribution limit is $15,000. Also, don’t forget to make catch-up contributions if you are 50 or older by the end of the year.
The annual gift tax exclusion amount increases to $12,000 per donor per donee in 2006. This means that you can give up to $12,000 to any other person tax-free. If the gift is split with your spouse, you can give up to $24,000. This is a great way to pass on wealth without paying gift tax.
Consider contributing to the Colorado Scholar’s Choice 529 plan to fund college tuition for your children or grandchildren. These contributions can be deducted on your Colorado return. Distributions used for qualified education expenses are not taxed. Used in conjunction with the gift tax exclusion, a contribution on behalf of your children or grandchildren can be made without paying gift tax and can be deducted on your Colorado return.
Conclusion
As we said at the beginning, this letter is intended to give you just a few ideas to get you
thinking about tax planning for 2006. Please don’t hesitate to call if you would like more
information or want to schedule a tax planning strategy session. We are at your service!
