2006 Tax Legislation - How the Tax Reconciliation Act Impacts on Individuals

Congress recently passed the Tax Increase Prevention and Reconciliation Act (Tax Reconciliation Act). Tax legislation is always complicated and the new tax cut package that Congress just passed is no exception. We know that you've heard a lot about the new tax cuts. We want to take a few minutes to explore some of the important tax incentives in the Tax Increase Prevention and Reconciliation Act  that could help lower your tax bill. 

The new tax cut was a long time coming. Negotiations started in 2005. That's why the new law is officially known as the Tax Increase Prevention and Reconciliation Act . The tax incentives in the new law apply in 2006 and beyond. 

Dividends and capital gains. Three years ago, Congress gave investors a valuable tax break when it reduced the maximum dividend tax rate from a high of 35 percent (depending on income tax bracket) to 15 percent and the maximum capital gains tax rate from 20 percent to 15 percent. However, the rate reductions were temporary. As originally enacted in 2003, they were scheduled to expire on December 31, 2008. 

The Tax Reconciliation Act extends the reduced rates for two more years. Under the new law, you can take advantage of the lower dividend and capital gains tax rates through December 31, 2010. 

The two-year extension opens the door to many tax planning opportunities. Our office can help you review your portfolio and make some important strategic decisions on how to maximize your tax savings because of the extension. Moreover, and this is very important, the lower rates do not apply to all dividends and capital gains. We can help you determine if your dividends or capital gains qualify for the lower rates. 

Kiddie tax. The "kiddie" tax is designed to prevent income-shifting from parents to children to circumvent the tax laws. Under the old rules, children under the age of 14 were taxed at their parent's marginal tax rate. For 2006, the "kiddie" tax kicks-in when the child has more than $1,700 in passive (unearned) income and other criteria are met. 

The new law raises the age limit from 14 to 18. This change is effective immediately. Because it is effective immediately, you need to revisit your tax planning for 2006. This is especially important if you are saving for a child's college or other post-secondary school educational expenses. Rather than selling off investments held in your children's accounts before they reach age 18, it may be preferable to use other resources to fund their education, postponing a stock sell off until after their 18th birthday. By doing so, you may be able to ultimately reduce their Federal tax rate on capital gains from 15% to 5% (or perhaps even 0% for sales in 2008).

AMT relief. The alternative minimum tax (AMT) is quickly becoming the "regular" tax for many two-income couples with children and others supporting large families. The AMT was originally intended to prevent very wealthy individuals from evading taxes. That was more than 30 years ago. Because the AMT was not indexed for inflation, and because of some other factors, it now ensnares many high/middle-income taxpayers. 

Congress could make some fundamental changes to the AMT so it goes back to its original purpose. So far, it has not; in a way, it is too used to the tremendous tax revenues that the AMT brings in. Instead, however, Congress has given taxpayers some temporary incentives designed to cushion the blow of the AMT. 

The Tax Reconciliation Act raises the AMT exemption levels. The AMT exemption for single taxpayers rises to $42,500 for 2006. The AMT exemption for married couples filing jointly jumps to $62,550 for 2006. The amounts are slightly higher than in 2005 to account for inflation over the past few years.  

Although many Washington observers expected that Congress would extend the AMT exemption amounts for at least one more year, the inflation adjustments are a welcome surprise. 

Taxpayers also will continue to be able to use the nonrefundable personal credits against regular and AMT liability. These include the dependent care, elderly and disabled, the new consumer energy credits, and the Hope and Lifetime Learning tax credits. 

The AMT is not only complex, it is often unintelligible to the average taxpayer. Our office can help you understand the basic concepts behind the AMT and execute a tax strategy that may help minimize your tax bill. The incentives in the new law certainly help reduce the AMT burden and may benefit you. 

Roth IRAs. Roth IRAs, like traditional IRAs, are excellent vehicles to save for retirement. They also have many rules that impact how much you can save and when you can withdraw your savings. Under current rules, individuals with modified adjusted gross incomes of more than $100,000 could not convert a traditional IRA to a Roth IRA. The Tax Reconciliation Act removes this limitation starting in 2010. 

Even though 2010 is four years away, now is the time to start a Roth IRA conversion plan. If you are thinking about retiring, for example, you could consider possibly rolling over your 401(k) balance to an IRA, which you will convert to a Roth IRA. Although contributions to a Roth IRA are not tax deductible, unlike contributions to a traditional IRA, your savings in a Roth IRA grow tax-free, not just tax-deferred. Unlike a regular IRA, there are no minimum distribution requirements during your lifetime. If you die, your Roth IRA can be rolled over into a Roth IRA for your surviving spouse. The savings there grow tax-free as well. Upon your spouse's death, the Roth IRA can then grow tax free for your children as they withdraw funds from the Roth IRA over their lifetime. The tax break in the new law may certainly work to your advantage. You basically pay a one time tax for the privilege of converting to a Roth IRA, and after that the Roth IRA is immune from any further taxation.

Offers-in-compromise. Many taxpayers who are burdened with large tax debts seek to negotiate an offer-in-compromise with the IRS. The IRS is notoriously unenthusiastic about offers-in-compromise. Under the new law, taxpayers are required to make partial payments of their liability in addition to any user fee now imposed by the IRS. However, the user fee will be applied to the outstanding liability. The new law also affects taxpayers who want to make lump sum offers and installment offers. In one piece of good news, if the IRS fails to process an offer within two years, the offer will be deemed to be accepted. 

More developments. The Tax Reconciliation Act also permits capital gain treatment for self-created musical works. In addition to the incentives described in this communication, which are targeted to individuals, the new law also gives business taxpayers some significant breaks, such as enhanced small business expensing. We'll cover those in a separate email alert.

If you have any questions about these valuable new tax cuts, give our office a call. We can explore in much more detail how some of them could result in future tax savings.