The Tax Increase Prevention and Reconciliation Act signed into law by President George W. Bush in May contains good news for investors with taxable capital gains and dividend income. It also offers upper-income taxpayers a Roth IRA conversion opportunity and extends immediate relief from the Alternative Minimum Tax. The law has its downsides, too. One of these will raise revenues by expanding the reach of the "kiddie tax" on unearned income from assets owned by a child. A look at the specifics can help you better gauge how these provisions may affect your tax liability and influence your planning both now and in the years ahead.
Capital gains and dividends
The new legislation extends favorable tax rates on long-term capital gains and qualified dividends to the end of 2010. Under legislation passed in 2003, tax rates on capital gains and dividends were reduced to 15 percent for middle- and upper-income taxpayers but were scheduled to revert to their former higher rates at the end of 2008. The extension gives them the same expiration date as other provisions of the 2003 law.
Keep in mind that capital gains on assets held for less than one year continue to be taxed as ordinary income, as do dividends distributed by some real estate investment trusts and certain tax-exempt organizations. Additional rules apply to dividends on shares owned for less than a required minimum holding period and on shares involved in hedging transactions.
Roth IRA conversions
Beginning in 2010, the new law will eliminate the income cap on converting tax-deferred traditional IRAs to Roth IRAs. The difference between the two is that Roth IRAs offer tax-free qualified withdrawals. Until 2010, conversions are allowed only when the account owner's adjusted gross income is less than $100,000 (regardless of filing status). If you are considering such a move, bear in mind that a conversion is treated as a one-time taxable distribution from the traditional IRA. Talk to a tax professional about how this rule may relate to your situation before you act.
The Alternative Minimum Tax (AMT) operates in parallel with the regular federal income tax system, which means that if you already are paying at least as much under the regular income tax as you would under the AMT, you don't have to pay the AMT. To provide middle-income taxpayers with some relief from the federal alternative minimum tax, the new tax law raises the exemptions for the 2006 tax year to $62,550 for married joint filers and $42,500 for single filers. The exemptions will revert to lower levels next year unless Congress acts to increase them.
The legislation also extends a provision allowing taxpayers to use nonrefundable personal credits, such as certain education and dependent care credits, to offset AMT liability. This extension also applies only for the 2006 tax year.
The 'kiddie tax'
For parents who pass income-producing assets to children -- through a Uniform Gifts/Transfers to Minors Act account, for example -- tax rules that previously applied to children under age 14 now apply to children up to age 18, beginning in the 2006 tax year. Under these "kiddie tax" rules, the first $850 of unearned income from assets owned by a child is free from federal taxes. The next $850 is taxed at the child's rate, which is typically lower than the parents' rate. Any unearned income above that level is taxed at the parents' rate, assuming that it's higher than the child's rate.
While there is nothing that can be done to avoid any negative effects of the immediate change in the kiddie tax, other provisions of the new law give taxpayers some breathing room. In the case of the AMT, it's just a matter of months before Congress will have to revisit the creeping effect of this tax, which has never been indexed to inflation. Although many lawmakers would like to repeal or reform the AMT, the record high federal budget deficit has left little flexibility.
With lower individual marginal tax rates, marriage penalty relief and the temporary repeal of the estate tax all due to expire at the end of 2010, Congress still will face more difficult tax policy decisions down the road. That is why it may be a good idea to take a longer-term view of your tax situation and, in doing so, consider the potential impact that higher tax rates may have on your overall financial affairs in the years to come.
Wilsey is a registered principal with Linsco/Private Ledger, a member of the SIPC. Hear him on KFMB AM 760 Saturdays at 8 a.m., and see him on Channel 8 News and CNBC. Contact him at email@example.com. Comments may be published as Letters to the Editor.