Extension Explication

While a number of the provisions in the recently passed $70 billion tax package, the “Tax Increase Prevention and Reconciliation Act of 2005,” will have a direct effect on how advisors plan for their clients–namely repeal of the Roth IRA limits, extending the Kiddie Tax to age 18, raising the AMT exemption for 2006, and extension of the 15% long-term capital gains rate–questions remain whether the most beneficial provisions with future effective dates will occur at all.

Some of the tax provisions that didn’t make it into the new tax bill recently signed by President Bush are expected to get tacked on to the compromise bill on pension reform that’s stuck in a House-Senate conference and is due out this year. Those provisions may include extensions on deductibility of state and local sales taxes, charitable giving incentives, and certain college expenses, says Mary Bell, government relations manager for the Financial Planning Association. Senator Chuck Grassley (R-Iowa), chairman of the Senate Finance Committee, originally wanted to move those provisions into a separate bill, but all signs point to the provisions being added to the pension bill “because it’s the only bill moving,” Bell says. Congress failed to unveil a pension bill by its Memorial Day deadline, and House Majority Leader John Boehner (R-Ohio) recently voiced his frustration at the prolonged process, saying he wants Congress to hammer out a compromise bill before the July 4 recess. The college expenses provision may address permanency of 529 college savings plans, which is an issue that’s still looming.

Meanwhile, another vote on repealing the estate tax is likely this year. Last month the Senate fell three votes short of the 60 votes needed to approve a permanent repeal of the estate tax. Senate Majority Leader Bill Frist (R-Tennessee) vowed that the Senate would indeed vote again this year on “wiping this vicious tax from the books.”

The Kiddie Tax

The new law’s Kiddie Tax provision is the one with the most “immediate impact,” says Jim Holtzman, a planner with Legend Financial Advisors in Pittsburgh. In 2006, $1,700 is exempt from parents’ taxation on kids’ assets, he explains. The first $850 of unearned income is tax-free under law–which is the standard deduction parents have, he says. The next $850 is taxed at the child’s tax bracket, which is generally lower than the parents’. “Anything above $1,700,” notes Holtzman, “is taxed at the parents’ tax rate, even if it’s in the child’s name.” Previously, any child under the age of 14 was subject to the standard deduction rule; under the new law, it’s been raised to age 18. From an asset accumulation standpoint, the new law is good news because it gives money set aside for the child more time to grow. “From age 14 to 18 may be one of the higher periods of their asset balance growth,” he says.

Ken Weingarten, a planner with Weingarten & Associates in Trenton, New Jersey, says he recommends clients with children shift highly appreciated assets to their children in advance of needing funds for educational expenses. “Raising the age to 18 will require changes in how some of my clients plan for these expenses,” he says. It seems unfair to Weingarten that the age change is retroactive to the beginning of 2006, since “some folks have already done an asset transfer and realized gains in a child’s name for 2006,” he argues. “These folks are stuck now paying more in taxes than they anticipated.”

Steven Podnos, a planner with Wealthcare LLC in Rockledge, Florida, told clients in a recent newsletter that now that the Kiddie Tax applies to older teens, “the first $1,700 of unearned income for children remains lightly taxed.” He said that “educational investing for children that might produce income over this amount should be tilted toward 529 plans to avoid taxation in the parents’ tax bracket.”

Traditional and Roth IRAs

The way it stands now, anyone whose AGI is more than $100,000 is barred from converting her traditional IRA to a Roth IRA. The new law, however, repeals any income limitations on conversions come 2010. Weingarten wonders if this new rule will ever see the light of day, considering “we are two Congressional elections and one Presidential election away from that change taking effect.” If the Democrats take control, he says, “many of the future changes” included in the bill may never take hold. Planner Holtzman adds that the huge budget deficit may also prevent the repeal from occurring.

Why wait until 2010 to allow such conversions? That’s the year the government needs revenue. “The government has revenue generators until [2010], and then there’s a big blackout period between 2010 and 2013 where there’s no revenue coming in,” says the FPA’s Bell. When traditional IRA holders convert to a Roth IRA, they have to pay taxes up front, so the government gets the money immediately. If the money was rolled into a deductible IRA, Bells says, the government doesn’t get the money until the accountholder retires.