From the September 2006 issue of Research Magazine • Subscribe!

Get Moving on New Tax Act

There is nothing like a new tax bill to give you something to talk about with your clients. The Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005 was signed into law May 17. The bipartisan Congressional Research Office estimates the cost to be $70 billion. The main purpose was to extend the favorable dividend capital gains rates and to provide relief for a growing number of middle-income families who pay the alternative minimum tax (AMT). But like all legislation, it also included some surprises. If you would like to be proactive with your clients, you should review the ones that apply to them and then refer them to their tax professional before the end of this quarter.

Dividends and Capital Gains

First, the expected: Dividends and long-term capital gains will continue to be taxed at 15 percent until 2010, instead of 2008. This bodes well for the financial markets. For taxpayers in the 10 percent and 15 percent tax brackets, the rate is only 5 percent. Of course, you need to factor in state income taxes, but it's still a very good deal compared to income earned from salaries and wages. However, because of the AMT, taxpayers subject to it actually pay an effective rate of 21 percent to 22 percent, plus state taxes.

The Alternative Minimum Tax (AMT)

To nobody's surprise, Congress provided only minimal relief for the AMT for 2006. Generally speaking, those who were close to paying it in 2005 probably won't have to pay it in 2006, as they would have without this legislation. However, this relief is only temporary for 2006. In 2007 we go back to the schedule used in 2000.

The AMT gets us closer to a flat tax by eliminating the ability to fully utilize certain itemized deductions and tax credits, or fully take advantage of capital gains. Previously, only the foreign tax credit, adoption credit, child credit and saver's credit were to be allowed to reduce the alternative minimum tax in 2006. The Act extends the ability to reduce alternative minimum tax in 2006 to the following credits: dependent care credit, credit for the elderly and disabled, energy-saving credits, tuition credits and certain homeowner credits.

Be careful here. If Congress doesn't pass relief for 2007, the AMT situation could be much worse next year. In that case, it may be advisable to realize capital gains and maximize your AMT preference items and other deductions this year. In all cases, involve your clients' tax professional in the decision-making process. It's better for the client and it will help you build solid referral relationships with other professionals.

The "Kiddie" Tax

This will be an unpleasant surprise for many parents. Previously investment income exceeding $1,700 in 2006 for children over age 14 was taxed at the child's tax bracket. Now it will be taxed at the parent's highest marginal bracket until the child turns 18. This changes the game with the custodial UGMA/UTMA accounts typically used to fund college and other discretionary expenses on behalf of a child. Thus, the income shifting technique of transferring assets to minors will not work. This makes the Section 529 college savings plans a better deal, although converting an existing custodial account to a 529 plan raises a few caveats.

The main one is that only cash can be used to establish a 529 plan, which may mean triggering capital gains taxes in the UGMA/UTMA account -- now taxed at the adult's rate. Also, unlike a 529 plan, the UGMA/UTMA assets converted to a 529 plan remain the assets of the child and cannot be transferred to another relative. Furthermore, at the age of majority (18 or 21, depending upon your state) the child has the right to take over the account and cash it in. In short, with a decent sized UGMA/UTMA account with investment gains, there aren't a whole lot of alternatives, except to start spending it down, as described below.

If you establish a custodial account for a client, you need to have a very valid non-tax reason to do so. That reason would mostly be to earmark certain funds for the benefit of a child. Unlike a 529 plan, in which the funds can only be used for post-secondary education, money in a custodial account can be used for other purposes prior to college. Generally speaking, funds in custodial accounts can be used for expenses that go beyond what a parent is legally required to provide a child (such as food, clothing, shelter and health care). Examples could be the purchase of a car, computer, summer camp, gymnastics lessons or a musical instrument.

Section 179 Small-Business Expenses

Your small business owner clients will be pleasantly surprised to learn that they have until 2009 to expense up to $100,000 of qualified business property assets, indexed for inflation. For 2006, the amount is up to $108,000, reduced by the amount by which the cost of the property exceeds $430,000. Without legislation it would have fallen to $25,000 in 2008, with a cap of $200,000.

Roth Conversions

This is a big surprise, and whether or not it is a pleasant one depends upon your client's generation, income level, and investment assets. Previously, only those with adjusted gross incomes less than $100,000 could convert their IRAs to a Roth IRA. After the latter of age 59 1/2 or five years, the money can be withdrawn tax-free. In 2010, the $100,000 income limit will be removed. Anybody, regardless of income level, can convert and spread the tax bill equally over the next two years, if they wish. They also lock in today's lower income-tax rates, which are scheduled to sunset in 2010.

This suggests a strategy: Fund an IRA each year, whether it is fully deductible or not. (The limits are $4,000 for those under age 50, $5,000 for those above.) Then in 2010, if an analysis shows that a conversion is best for your clients' objectives, have them convert their IRA to a Roth, paying the taxes with funds outside the IRA. Those higher-income taxpayers who made non-deductible IRA contributions will have little or no income taxes to pay at the time of conversion. The assets continue to grow tax-deferred and tax-free -- forever.

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MARIE SWIFT is president of Impact Communications (www.impactcommunications.org), a marketing and communications firm for independent advisors.

RON KELEMEN, CFP, is an advisory associate of The H Group in Salem, Ore., and is celebrating his 25th year as a financial advisor (www.planningvisionprocess.com). He is a contributing author to the following books: Ways and Means: Maximize the Value of Your Retirement Savings, Strictly Business: Planning Strategies for Privately Owned Businesses, and Living and Learning: Achieve Retirement and Education Security.

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