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.