President Bush recently signed the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA) into law, creating many new opportunities and unexpected challenges, especially for individuals saving for retirement or a child's education.
The TIPRA legislation includes dozens of new provisions. Following are four of the most important:
• Capital gains and dividends: The previous tax law's lower rates on capital gains and dividends have been extended through 2010, rather than expiring after 2008 as originally scheduled.
• Alternative minimum tax (AMT): Taxpayers who benefit from certain provisions of the tax law may have to pay an additional tax called the alternative minimum tax. In 2006, an exemption of $62,550 for married couples and $42,500 for single taxpayers will be allowed in calculating the AMT. The exemption is phased out at higher levels of income.
In addition, TIPRA allows taxpayers to use certain tax credits, such as the dependent care credit, the credit for the elderly and disabled, energy-saving credits, tuition credits and some homeowner credits, to reduce the AMT.
• "Kiddie" tax: Effective immediately, TIPRA expands the reach of the "kiddie tax" by making it applicable to children under the age of 18 (rather than the prior age of under 14). The kiddie tax is the tax paid on a child's unearned income that is calculated at the parent's highest marginal tax rate.
• Roth IRA conversions: In 2010, individuals who earn more than $100,000 in modified adjusted gross income will be able to convert a Traditional IRA to a Roth IRA. Previously, only individuals who made $100,000 or less were eligible to convert to a Roth IRA. An attractive advantage of a Roth IRA is that you can take tax-free withdrawals after five years if you meet certain requirements.
Favorable Tax Rates Are Extended
The reduced rates on capital gains and dividends were scheduled to expire at the end of 2008. TIPRA extends for the 2009 and 2010 tax years the 0 percent and 15 percent rates on adjusted net capital gains and dividends. Here are a few actions investors may want to consider:
Investors seeking current income with some growth opportunities may want to consider shifting a larger percentage of their portfolios to high-quality equities that pay substantial dividends.
Distributions from tax-deferred accounts such as 401(k)s and IRAs are typically taxed as ordinary income. If you're withdrawing income from your retirement accounts, consider favoring fixed-income investments in these accounts and moving growth equities to your taxable accounts.
If you are heavily invested in highly appreciated securities, now may be the ideal time to realize your gains at the lower capital gains rate and diversify your portfolio.
AMT Income Limits Rise and Tax Credits Available
One of the consequences of the current tax law is that many taxpayers are at risk for triggering the AMT, an alternative to ordinary income tax that has ensnared more and more taxpayers every year.
The AMT forces many taxpayers to give back some of the deductions they can take against their regular income tax, such as certain home equity loan interest, real estate and state and local taxes.
For 2006 only, TIPRA increases the amount of the AMT exemption for married couples filing jointly to $62,550. (The AMT exemption was $58,000 for 2005 and was scheduled to go down to $45,000).
The exemption for single taxpayers is raised to $42,500. (It was $40,250 for 2005 and was scheduled to go down to $33,750.)
The exemption is phased out at higher levels of income. Note that this is a one-year "fix" and Congress will need to revisit the issue.
To be sure you're taking advantage of the newly created benefits, and avoiding the pitfalls, be sure to speak with your tax and financial advisors. For more information, call me at 689-8704 or e-mail william.a.creekbaum@smithbarney.com.
• William Creekbaum, MBA, CFP, a Washoe Valley resident, is senior investment management consultant of SmithBarney, a financial services firm serving Northern Nevada at 6005 Plumas Street, Ste. 200 Reno, NV 89509.