The Tax Increase Prevention and Reconciliation Act of 2005, signed by President Bush on May 17, 2006, took so long in coming that it still carried the "Act of 2005" label.Far from having no surprises, however, the final bill contained a generous handful of provisions that had been far out of the money only weeks before. While some of these unexpected changes impact businesses, the most high-profile surprises appear to focus on the individual taxpayer. These include the lifting of the adjusted gross income cap on Roth IRA conversions, the raising of the "Kiddie Tax" age limit to 18 years, and the increase in the AMT exemption amounts.
This column reviews some of the planning strategies that might be used in an immediate response to clients who are asking what to do now in connection with those three changes.
Perhaps the biggest buzz created by the new law is the lifting of the $100,000 AGI limit on taxpayers able to convert regular IRAs to Roth IRAs. While this break is delayed until tax years beginning after 2009, some urgency is created in having the conversions take place in 2010 because of the prospects of the post-2010 sun-setting of the existing low individual income tax rates first put into place by the 2001 Economic Growth and Tax Relief Act.
Conversions to Roth IRAs are especially attractive to high-income taxpayers, since they usually continue to find themselves in high brackets after retirement, and they don't need distributions to live on after retirement. Higher-income taxpayers tend to want to keep money in a tax-deferred account as long as possible.
Perhaps equally as important, higher-income taxpayers can usually more ably pay the tax on a conversion to a Roth IRA without using funds from that account. If the income tax on the Roth conversion is paid out of a distribution from the converted IRA, that amount is not only taxed as income, but an early-distribution penalty of 10 percent usually applies.
Since Roth IRA distributions are not required, and when made are not taxable to the taxpayer or to the taxpayer's heirs, conversion of Roth IRAs post-2009 is being recommended as part of estate planning.
Heirs of Roth IRAs, in turn, can retain the balance in the Roth IRA and take nontaxable periodic required minimum distributions based on life expectancy. As a result, income can be sheltered for so many years that estimates of increasing initial Roth IRA conversion balances almost a thousandfold have not been unheard of.
* 401(k) plan rollovers to traditional IRAs. While Roth 401(k) accounts have been allowed since January 2006 under the 2004 Jobs Act, regular 401(k) account balances cannot be converted into a Roth 401(k). The 2006 act does nothing to change this rule. Regular 401(k)s, or for that matter other qualified retirement plans, cannot be rolled over into a post-2009 conversion Roth IRA, irrespective of AGI.
However, there is a way around the 401(k) conversion prohibition for many taxpayers. The participant in the 401(k)s and other plans may roll over those account balances into traditional IRAs that are then, on or after 2010, rolled over into a Roth IRA. Of course, not everyone can just pull her balance out of a 401(k) plan; a plan amendment must permit it or, more likely, those who are changing jobs or are otherwise leaving employment can choose to roll over the balance into an IRA, rather than have it remain in the plan.
Contributions to nondeductible IRAs. Contributions to nondeductible IRAs may provide still another way for high-income taxpayers to generate assets in a regular IRA in order to have the opportunity to roll them over into a Roth IRA post-2009. Those participating in a qualified plan and ineligible to contribute to a deductible IRA nevertheless may contribute to a nondeductible IRA and then roll them over any time after 2009 into a Roth IRA.
Viewed from another angle, the nondeductible IRA-to-Roth IRA conversion in effect converts contributions to nondeductible IRAs into allowable contributions to Roth IRAs for taxpayers of all income levels. Since anyone can make annual contributions to a nondeductible IRA and now, starting in 2010, anyone can roll over those regular IRAs into a Roth IRA at any time, the prohibition against contributing to a Roth IRA is effectively eliminated.
TIPRA has raised the upper limit of the reach of the Kiddie Tax to 18 for tax years after 2005. This has the effect of exposing unearned income above $1,700 (for 2006) of children under age 18 to taxation at the parent's income tax rate. Prior to the amendment, investment income of a child age 14 and up was includible in the child's gross income and taxed at the child's tax rate.
While the "Kiddie Tax" name probably will continue, many individuals approaching 18 years of age are no longer kids. If the under-18-year-old is married and files jointly, the Kiddie Tax won't apply. Also, remember that while older children are likely to earn money on summer and part-time jobs, the Kiddie Tax only applies to unearned income.
Plans to sell appreciated securities set aside for college when a child turned 14, especially in cases of stock with low carryover basis in gift situations, need to be revised. Especially painful is the loss of an anticipated non-Kiddie Tax sale when the capital gains tax rate for lower-income taxpayers will be zero in 2008, 2009 and 2010.
Planning techniques to cope with the extended tax include investing in long-term assets for capital appreciation, rather than annual income, and reliance on IRAs (if the child has earned income) or tax-advantaged education savings plans, such as Section 529 plans and Coverdell savings accounts.
While assets for children are usually held in anticipation of paying for college, the conventional wisdom goes against holding them until the last moment in appreciating stocks that are generally more volatile over the short term than T-bills or other fixed-income assets. On the other hand, taking a chance on the market and holding them until the year the child turns 18 may work, especially if the funds are being socked away for graduate school or other, more long-term purposes. Consider also that if the child won't turn 18 until after 2010, when capital gains rates are set to go up, selling now becomes more of an option.
Presumably market risk within a family setting also could be minimized if a parent converts his assets into a more secure investment, such as CDs, to mirror the amount of securities held by the child to help cover the downside market risk.
For those unfortunate 14-through-17-year-olds who sold securities earlier in 2006, before the new law was passed, the surprise of having to pay a Kiddie Tax may be increased by the realization that part of that tax may be due immediately in the form of higher estimated tax payments. The sales are irrevocable and the new tax law offers no relief for these transactions done based on the assumption of being governed by an existing set of rules.
While almost everyone expected the temporary "fix" to the alternative minimum tax for 2006, several finer points may have escaped the attention of tax practitioners until it was a "done deal" after the president signed the bill on May 17.
Although the AMT exemption amounts for individuals are increased slightly for 2006 (from $40,250 and $58,000 to $42,500 and $62,550 for single and married individuals, respectively), the threshold levels for calculating the phase-out remain the same: a reduction of 25 percent for each $1 of AMT income in excess of $150,000 for joint filers, $112,500 for unmarried individuals, and $75,000 for married individuals filing separately or estates and trusts.
The slight increase in the AMT exemption may be sufficient to bump some 2005 AMT taxpayers into paying only the regular tax in 2006, assuming an equal amount of income and deductions. However, the usual inflation adjustments on the regular income tax rate brackets for 2006 may serve to place enough of these taxpayers' marginal income into a lower rate bracket, ironically thereby making them slightly more vulnerable to the AMT.
While the inflation-adjusted amounts will only make the AMT go a few dollars one way or another for most taxpayers, the additional provision that allows nonrefundable personal tax credits to offset the AMT in 2006 will make a bigger difference for many more taxpayers.
This is especially the case for the new-for-2006 consumer energy tax credits. The ability to use the consumer home energy credits against AMT in 2006 as the result of the new law for 2006, but so far not for 2007, suggests that AMT-vulnerable taxpayers should make qualifying energy expenditures in 2006 rather than in 2007. Otherwise, there is a risk that the old rules will prevent use of the energy credits, which are available only for the short 2006-2007 window, from offsetting AMT in 2007. Note, however, that the vehicle and refueling energy credits cannot offset AMT liability in either year.
We will be living with the results of the Tax Increase Prevention and Reconciliation Act for a while. Strategies to avoid the Kiddie Tax for college-bound teenagers, as well as to plan to maximize use of the consumer-residential energy tax credits in 2006 against AMT, appear to be the most urgent considerations for individual taxpayers because of the effective dates of those provisions.
Taking advantage of the Roth conversion provision will prove to be the biggest tax saver for many clients, and decisions in 2006 that will add to regular IRAs either through rollovers or nondeductible contributions should not be postponed. As with any tax change, however, clients looking forward to a Roth conversion should remain flexible and not count on a single strategy. In fact, the unbelievably rich benefits that might be gained from a Roth conversion put it in danger of added restrictions and give-backs by another Congress before its 2010 effective date.
What Congress giveth, Congress can taketh away.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a Wolters Kluwer business.
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