2006 Year-End Tax Planning

Many taxpayers may find it difficult to keep track of the growing volume of complex, new developments that can overwhelm even a knowledgeable person. This is particularly true when Congress continues to pass new tax laws in rapid succession. This article is intended to help keep you up-to-date on key developments during the past year, including the mammoth Pension Protection Act of 2006 and the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Thank heaven for acronyms.

The following is only a summary of the most important tax developments that may affect you, your family, your investments, and your livelihood. Please call us if you’d like to discuss any of these developments in more detail and determine what steps you should implement to take advantage of favorable developments and to minimize the impact of those that are unfavorable.

TIPRA brings some tax relief

TIPRA was signed into law on May 17. This bill reconciles the Budget Resolution of 2005 and provides a variety of tax breaks, some of which may even apply to you.

Small Business Expensing

Current tax laws allow a small business to expense up to $100,000 of depreciable assets per year. This provision was due to “sunset” (expire) at the end of 2007. But, under TIPRA, the effective date is extended to Dec. 30, 2009, thus allowing small businesses more time to plan their purchases.

Alternative Minimum Tax (AMT)

Most folks agree that the AMT should be completely overhauled. But, our politicians have been reluctant to take drastic action because tax revenues could be decreased by as much $1 trillion. That’s a lot of pork. So, as an interim measure, Congress has temporarily increased the AMT exemption — but only through 2006.

In addition, nonrefundable personal tax credits can now be claimed against the AMT, helping to offset both regular and AMT tax liability. This includes such credits as the dependent care credit, the credit for the elderly and disabled, the credit for interest on certain home mortgages, the Hope credit for college expenses and the Lifetime Learning credit.

Capital Gains Rate

Today, most long-term capital gains are taxed at 15%. However, the rate decrease was only temporary and would have increased at the end of 2008 when this provision was scheduled to sunset. TIPRA extends this lower rate two more years, so the provision now expires at the end of 2010.

Tax Rate on Dividends

Here’s another fix for another sunset. Qualified dividends are currently taxed at a maximum 15% rate under a provision that was to expire at the end of 2008. Like the capital gains rate extension, this provision has been extended through 2010.

Expansion of the “Kiddie” Tax

Previously, only children under the age of 14 were taxed on unearned income at their parents' tax rate. The new law bumps the age threshold to 18 (with some exceptions). Kids are still entitled to $850 of tax-free income, and the next $850 is taxed at the child’s rate before the kiddie tax applies.

Roth IRA Conversions

It used to be that if you earned more than $100,000 (adjusted gross), you were not allowed to convert a traditional IRA to a Roth account. Not any more. TIPRA eliminates the income cap entirely. Although this provision won’t be effective until 2010, it will then allow an individual of any income level to make a Roth conversion. By paying current income tax on the conversion, the IRA owner can avoid income tax on all future income and appreciation in the account.

Pension Protection Act affects individuals and businesses alike

On Aug. 17, 2006, the Pension Protection Act of 2006 (PPA) was signed into law. And I know you’ll be shocked to learn that this 900+ page law is complex. The PPA makes a host of changes relating to pension plans and their beneficiaries, and also revises key charitable giving rules. We’ve summarize some of the key changes below.

Cash Balance Plan

This is a relatively new type of company sponsored retirement plan and the PPA outlines the rules for setting one up. A Cash Balance Plan determines an employee's retirement benefit by reference to his or her “cash balance” in a hypothetical account. Each employee's hypothetical account balance is based on annual pay credits to his or her account, plus interest credits on the account. Are you still with me? These plans tend to favor younger workers and a traditional pension plan can be converted to a cash balance plan if a number of requirements are met.

Defined Contribution Plans

Defined contribution retirement plans (or profit sharing plans) that are exclusively invested in employer securities must offer participants at least three other investment choices. This is generally effective for plan years beginning after 2006.

Accelerated Vesting Schedule

This now applies to all employer contributions made to defined contribution retirement plans (currently, faster vesting only applies to matching employer contributions). Again, this is generally effective for plan years beginning after 2006.

Annuity Payout Option

Retirement plans that provide for a joint and survivor annuity payout option must now offer as an option a joint and 75% survivor annuity benefit. This is generally effective for plan years beginning after 2007.

Investment Advice from Fiduciary Advisors

Employers will now be able to offer investment advice through fiduciary advisors to participants in plans such as profit-sharing arrangements or 401(k) plans (as long as certain strict standards are met). Similarly, fiduciary advisors will be able to provide investment advice to owners and beneficiaries of IRAs (as well as health savings accounts, Archer medical savings accounts, and Coverdell education savings accounts). And, yes, you guessed it. This is generally effective after 2006.

Increases to Cost of Living Income Limits for IRA and Roth IRA Deductions

Post-2006 cost-of-living increases to the income limits at which the IRA deduction phases out when an individual (or spouse) is an active participant in an employer sponsored retirement plan. And post-2006 cost-of-living adjustments to the income limits at which the ability to make contributions to a Roth IRA phases out. Those were very complicated sentences, but it basically means more of us will be able to make deductible IRA and Roth IRA contributions. And that’s a good thing.

Non-Spouse Beneficiaries of Retirement Accounts

Non-spouse beneficiaries of retirement accounts will now be able to make rollovers to inherited-IRA accounts. Currently, only spouse-beneficiaries of retirement plan accounts can do this. The change gives much-needed flexibility to those who inherit retirement plan accounts from someone like a parent or uncle, for example. And yes, this is for distributions after 2006.

After-Tax Contributions to Retirement Plans

After-tax contributions to retirement plans may be rolled over to another retirement plan or to a tax-sheltered annuity, if the transfer is made via direct rollover and the receiving plan or annuity separately accounts for the after-tax contributions. Yep, it’s after 2006.

Direct Rollovers to Roth IRAs

Distributions from retirement plans, tax-sheltered annuities, and Section 457 plans can be rolled over directly into a Roth IRA, subject to the usual rules that apply to rollovers from a traditional IRA into a Roth IRA. Ask me later what a Section 457 plan is and what the usual rules are. And this one takes effect after 2007.

“When I’m 62”

Pension plans may now make distributions once a participant reaches age 62, even if he or she continues working. This change will make it easier for employees to phase into retirement (assuming their employers decide to adopt the change). This applies to distributions in plan years beginning after 2006.

Temporary Changes Become Permanent

There were many pro-taxpayer retirement plan and IRA changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 that were supposed to sunset at the end of 2010. These have now been made permanent. Including the ability to make catch-up (not “ketchup”) contributions to IRAs and 401(k)s after reaching age 50, increases in maximum IRA and Roth IRA contributions, and widened rollover choices.

Direct IRA Payments to Charity

If you are over 70½ you can now exclude up to $100,000 a year of distributions from IRAs (including Roth IRAs) that are paid directly by the IRA or Roth IRA trustee to a qualifying charity. If the exclusion is chosen, the donated amount can't be deducted as a charitable contribution.

No More Rags to Riches

The act toughened rules for certain contributions. For example, contributions of clothing and household items that are not in good used condition can't be deducted. In addition, the IRS may deny a deduction for any contribution of clothing or a household item with minimal monetary value, such as used socks or undergarments.

New Substantiation Requirements

A taxpayer won't be able to deduct a post-2006 contribution of cash, check, or other monetary gift unless he maintains as a record of the contribution a bank record or a written communication from the charity showing its name, the date of the contribution, and the amount of the contribution.