Tax Cuts and Tax Increases

A new tax law passed Congress just before Memorial Day. It contains important tax cuts and tax increases for investors and others. We gave the highlights last month. In this month’s visit we will delve into more details of the newly-enacted law, known as Tax Increase Prevention and Reconciliation Act of 2006.

• The major provision extends the 15% top tax rate on long-term capital gains and on dividends through Dec. 31, 2010. This still is not the permanent extension that many investors hoped for, but it reduces uncertainty for the next few years. 

• Many taxpayers are protected from falling victim to the alternative minimum tax in 2006 for the first time. The exemption amount for the AMT is increased to $62,500 for married couples filing jointly, $42,500 for unmarried individuals other than surviving spouses, and $31,275 for married individuals filing separate returns. 

  In addition, nonrefundable tax credits now may be used against the AMT in 2006. These tax credits include the dependent care credit, credit for the elderly and disabled, the HOPE Scholarship and Lifetime Learning credits, the credit for nonbusiness energy property, and the credit for residential energy property.

  Without these provisions millions of additional taxpayers would be subject to the AMT in 2006. But the provisions apply only to 2006. Congress must revisit the issue next year if it wants to avoid hitting many more taxpayers with the AMT. The law does nothing to reduce the scope of the AMT as it existed at the end of 2005. If you paid the AMT on your 2005 tax return, you likely will pay it for 2006 unless there are changes in your tax picture. (For details on the AMT, see the articles in the Tax Watch section of the Archive on the members’ web site.)

• The Kiddie Tax is increased. This is discussed separately in this month’s Grandkids’ Watch. 

• Interest paid on state and municipal bonds will be reported to the IRS beginning with all payments made in 2006. This does not change the tax treatment of the interest. But tax-free interest is used to limit tax breaks or increase taxes under the AMT, on Social Security benefits, and other cases. The IRS wants to be sure that taxpayers are properly including tax-exempt interest in these calculations. 

• Income taxes on foreign earned income are increased for many overseas taxpayers. The annual foreign earned income exclusion actually is increased from $80,000 to $82,400. But the housing exclusion now is set at a flat $11,536. This is significantly lower than many expatriates have been able to exclude in the past in many countries, so their U.S. will increase. 

• Business owners will continue to be able to deduct up to $100,000 of business equipment as a first-year expense under section 179 for tax years after 2007 and before 2010. In addition, the deduction amount is not scaled back until equipment purchases for the year exceed $400,000. 

• More taxpayers will be able to establish Roth IRAs. The income limits for creating and funding a Roth IRA are not changed. But in 2010 and later years the income limit is removed for taxpayers to convert a traditional IRA into a Roth IRA. Currently, to convert a traditional IRA into a Roth IRA a taxpayer cannot have adjusted gross income of more than $100,000, excluding income from the conversion. In 2010 and later years the income limit will be removed so that anyone can convert an IRA into a Roth IRA. 

  This is an incentive for higher income taxpayers to make non-deductible contributions to traditional IRAs beginning in 2006. In 2010, these IRAs can be converted to Roth IRAs. Also, when a person leaves an employer and rolls over a 401(k) balance to an IRA, that IRA can be converted to a Roth IRA in 2010 or later regardless of the individual’s income.

  For conversions in 2010 only, the converted amount need not be included in income in 2010. Instead, half the converted amount can be included in income in 2011 and half in 2012.

A Roth IRA is desirable because distributions from a Roth IRA are tax free. In addition, a Roth IRA is not subject to required minimum distributions during the original owner’s lifetime. In past visits we discussed the decision to convert a regular IRA into a Roth IRA. These articles are available on the Archive on the members’ web site.

The risk is that Congress might change the law before 2010. In that case you will have saved money in a nondeductible IRA that you cannot convert to a Roth IRA.

There already is another tax law in the works. It should extend some tax breaks that expired at the end of 2005, which primarily are business tax breaks. It also might include a broadening of charitable contributions and some other provisions. But no details have been made public.