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A Primer on the Tax Increase Prevention and
Reconciliation Act of 2005
On May 17, 2006, President Bush signed into law the Tax
Increase Prevention and Reconciliation Act of 2005, or TIPRA for
short. TIPRA affects taxes on capital gains and dividends, the
alternative minimum tax or AMT, the so-called kiddie tax, and
Roth conversions. Given all the changes, including those
affected most by the sunset measures introduced in 2001 and
2003, the new tax law heightens further the need to do financial
planning now rather than later. Here's a summary of the changes:
Capital gains and dividends
The Jobs and Growth Tax Relief Reconciliation Act of 2003
established a maximum tax rate of 15 percent for long-term
capital gains and "qualified" dividend income. These
rates were scheduled to expire after 2008, but TIPRA extends the
rates that apply in 2008 for two years, through 2010. For
taxpayers in the top four tax brackets, this means the tax rate
on long-term capital gains and "qualified" dividends
will be 15 percent for all years through December 31, 2010. For
taxpayers in the lowest two tax brackets (10 and 15 percent),
the capital gains and qualified dividend rates will be five
percent through 2007 and zero percent from 2008 through 2010.
Among other things, the extension may make it attractive for
wealthy families to give appreciated assets — up to the annual
gift tax exclusion limit ($12,000 in 2006 or $24,000 for married
couples who gift split) — to children who are age 18 or older, but
still in the lowest tax brackets. In essence, any appreciation
after the date of the gift should not be subject to gift taxes,
so experts suggest gifting securities that may have growth
potential. The extension also creates the opportunity for
Americans with low taxable income, including many retirees, to
harvest small amounts of capital gains at zero percent in
2008-2010.
Alternative minimum tax (AMT)
AMT exemption amounts, which were expanded under various tax
laws in 2001, 2003 and 2004, expired at the end of 2005. TIPRA
increases AMT exemption amounts beyond their 2005 levels for the
2006 year only. New AMT exemption amounts for 2006 are:
$62,550 for married individuals filing jointly
$42,500 for single filers
$31,275 for married individuals filing separately
The Act also resurrects, at least for 2006, the rules that
allow non-refundable personal tax credits (the dependent care
credit, the credit for the elderly and disabled, the Hope credit
for certain college expenses and the Lifetime Learning credit,
for instance) to offset the AMT.
In 2005, an estimated four million taxpayers were subject to
the AMT, but a recent report from Congressional Research
Services estimates AMT will affect 23 million Americans in 2007
without further tax law change. That's because the AMT is not
currently indexed for inflation, while the regular tax system
is, and consequently every year more average-income households
cross over into the AMT. Experts say the current relief is not
substantial and it's uncertain whether AMT will either be
reformed or repealed because of the substantial tax revenue
cost.
Roth IRA conversions
TIPRA eliminates the restriction that heretofore prevented
individuals with adjusted gross income exceeding $100,000 from
converting a traditional IRA to a Roth IRA. This change is not
effective, however, until 2010.
In addition, TIPRA enables individuals who convert a
traditional IRA to a Roth IRA in 2010 will automatically spread
the resulting reportable income over the following two years,
including the income ratably in 2011 and 2012. Individuals can
elect to report 100 percent of the resulting income in 2010 if
they wish. Of note, income tax is due on the full amount of the
traditional IRA conversion. With this change to Roth IRA
conversions, individuals who have traditional IRA balances can
weigh the benefits of converting some or all of their balances
to a Roth IRA. The true potential benefit of Roth IRA
conversions is this: the taxpayer would pay an income tax at
current rates because they believe the rate will be higher in
the future (either because the person who withdraws the money
will have higher income then, or because they believe that
Congress will raise tax rates in the future).
Kiddie tax
According to the IRS, the investment income of a young child
may, under some circumstances, be taxed at the child's parents'
top marginal income tax rate. This is commonly referred to as
the "kiddie tax." TIPRA increases the relevant age of
children that are affected by the kiddie tax rules from 14 to
18. Retroactively effective to January 1, 2006, children under
the age of 18 are subject to the kiddie tax rules. Exceptions
apply for minor children who are married and file a joint tax
return, and distributions from certain qualified disability
trusts. The implication of this change is that it prevents
parents from shifting any of their investment income to their
children in a lower tax bracket. This change affects families
wealthy enough to gift assets with significant appreciation or
short-term appreciation potential. It also affects parents who
were or are still saving for their children's college using
custodial accounts and affects a wide swath of young teenagers
who simply saved enough of their own money for future college
(or other purposes), who now get taxed at their parents' rates
for the income they saved entirely on their own.
TIPRA brought about a number of tax law changes, so it's a
good idea to consult with your financial planner to see how it
might affect your own situation.
July 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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