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    Investors Get an Extension--And a New Roth IRA Opportunity

    May seems to be the traditional month in Washington for tax cuts and May 2006 was no different from past years with Congress passing a $70 billion tax cut package, the Tax Increase Prevention and Reconciliation Act of 2005.

    Although one tax incentive—extending the dividend and capital gains tax rate cuts for two more years—has received the most press coverage, the new law includes many other important tax breaks that could help reduce your tax liability this year and in future years. Some of the important incentives in the new tax law are highlighted below.

    Dividends and Capital Gains

    Three years ago, Congress lowered the tax rate on certain dividends and capital gains. The rate reductions were temporary and were scheduled to expire after 2008. The new law extends the lower rates for two more years.

    The maximum tax rate on qualifying dividends and capital gains through December 31, 2010, is 15%. Not all dividends and capital gains qualify for the 15% rate. [For a complete description of which dividends qualify, see “Good News/Bad News: For Dividends, New Tax Law Means Lower Rates But More Headaches,” by Ellen J. Boling and Mark H. Gaudet, in the April 2004 issue of the AAII Journal.] For example, the maximum capital gains rate on collectibles is 28%. Taxpayers in the 15% and 10% rate brackets can take advantage of even more generous tax treatment.

    Roth IRAs

    Until Congress passed this new tax law, higher-income individuals could not convert traditional IRAs to Roth IRAs. Only individuals earning less than $100,000 could convert traditional IRAs to Roth IRAs.

    The new law removes this limitation starting in 2010. Even though 2010 seems a long way off, it’s important to start planning now to maximize this opportunity. [See the article “Planning Ahead for the New Roth IRA Conversion Opportunity,” to learn more about the options you may have under the new tax law.]

    AMT Relief

    Taxpayers who are liable for the alternative minimum tax (AMT) know that its bite can be painful. Congress has talked for years about reforming the AMT so it doesn’t impact as many middle-income taxpayers, but so far hasn’t made any substantial changes to the AMT rules.

    Instead, the new law extends some temporary measures designed to reduce the burden of the AMT. Through 2006, AMT taxpayers can take advantage of higher exemption amounts and use the non-refundable personal tax credits to offset regular and AMT liability. New AMT exemption amounts for 2006 are $62,550 for married individuals filing jointly, $42,500 for single filers, and $31,275 for married individuals filing separately.

    Kiddie Tax

    The “kiddie” tax rules require that a child’s unearned income, such as dividends and interest, be taxed at the tax rate of the parents. In most cases, the child’s parents will be in a higher tax bracket.

    Currently, the kiddie tax applies if the child is under age 14 and some other criteria are met. The new law raises the age limit from 14 to 18, and this change is effective immediately. That means that investment income for children ages 14 through 17 is now suddenly taxed at their parent’s tax bracket.

    Taxpayers who had envisioned the lower age limit being effective for 2006 now have to revisit their tax plans.

    Small Business Expensing

    Over the past several years, small businesses have been able to expense rather than capitalize more purchases because of higher expensing thresholds. The new law extends the more generous expensing thresholds for two more years.

    More Tax Cuts

    In addition to all of these tax breaks, the new law also:

    • Changes the offer-in-compromise rules;
    • Modifies the foreign earned income and employer-provided housing exclusion rules for U.S. citizens living abroad;
    • Extends and creates a new exception to Subpart F, which taxes foreign subsidiaries of U.S. companies;
    • Gives tax breaks to some environmental clean-up funds;
    • Simplifies the active trade or business test for certain corporate distributions;
    • Allows musical artists and publishers to elect special tax treatment;
    • Tightens earnings stripping rules to prevent abuses;
    • Requires withholding on payments made by some government agencies;
    • Repeals the FSC/ETI grandfather provisions;
    • Accelerates increased limits for industrial development bonds;
    • Cracks down on exempt organizations engaging in tax shelters;
    • Expands information reporting requirements for some tax-exempt bonds;
    • Lengthens the amortization period for certain expenditures by oil and gas companies;
    • Tightens the rules under the Foreign Investment in Real Property Tax Act;
    • Restricts the tax-free treatment for certain corporate cash-rich spin-off transactions;
    • Imposes loan and redemption requirements on pooled financing bonds;
    • Changes the timing of some estimated tax payments by large corporations;
    • Clarifies the domestic production deduction; and
    • Revises the tax treatment of loans to continuing care facilities.

    The new tax law impacts taxpayers across-the-board. Many of the new incentives build on tax breaks enacted in past years. Careful and efficient tax planning requires attention to the details and nuances in the new and extended incentives.

       Planning Ahead for the New Roth IRA Conversion Opportunity

    The Tax Increase Prevention and Reconciliation Act, signed into law on May 17, 2006, eliminates the $100,000 adjusted gross income ceiling for converting a traditional IRA into a Roth IRA. While this benefit won’t begin to apply until after 2009, plans to maximize this opportunity should start immediately for many taxpayers. For persons in the upper tax brackets, a Roth IRA can save a significant amount of tax, especially when incorporated into an estate plan in which Roth assets are eventually passed down to the next generation.

    Current Rules

    Currently, a taxpayer is allowed to convert a traditional IRA to a Roth IRA only if adjusted gross income in the year of conversion does not exceed $100,000. (Since this amount has remained unadjusted for inflation since its inception in 1998, the adjusted gross income level gets harder to get under each year and will become harder still through 2009.) A married taxpayer filing a separate return is currently prohibited from making a conversion.

    The amount converted is treated as distributed from the traditional IRA and, as a consequence, is included in the taxpayer’s income, but the 10% additional tax for early withdrawals does not apply. Starting in 2010, the $100,000 adjusted gross income cap is eliminated. All other rules continue to apply, which means that the amount converted to a Roth IRA still will be taxed as income at the individual’s marginal tax rate. One exception for 2010 only: Taxpayers will have a choice between recognizing the conversion income in 2010 or averaging it over 2011 and 2012.

    Significant Benefits

    While recognizing income sooner rather than later is usually not smart tax planning, in the case of this new opportunity to convert a traditional IRA to a Roth IRA, the math encourages it. The difference is twofold:

    • All future earnings on the account are tax free; and
    • The account can continue to grow tax free longer than a traditional IRA without being forced to be distributed gradually after age 70½ is reached.

    These can work out to be significant advantages, especially valuable to individuals with substantial assets who won’t need the Roth IRA account to live on during retirement. After a Roth IRA is inherited, only then is it subject to required minimum distribution rules, based on the beneficiary’s life expectancy.

    Contribution Limits

    The maximum annual contribution that can be made to a Roth IRA is phased out for a single individual with modified adjusted gross income (AGI) between $95,000 and $110,000, for joint filers with modified adjusted gross income between $150,000 and $160,000, and for individuals who are married filing separately with modified adjusted gross income between $0 and $10,000.

    There is no AGI limitation for non-deductible IRA contributions, however. The annual non-deductible contribution limit is that the total of all contributions to a Roth IRA and all deductible and non-deductible contributions to traditional IRAs may not exceed the lesser of $4,000 for tax years 2005 through 2007 ($4,500 in 2005 and $5,000 in 2006 and 2007 if catch-up contributions are made), or an amount equal to the compensation includable in the individual’s gross income for the year. Thus, allowable contributions to a non-deductible IRA are reduced to the extent of allowable Roth IRA contributions and deductible contributions made to traditional IRAs.

    Planning Strategies

    Even though 2010 seems a long way off, it’s important to start planning now to maximize this opportunity.

    Non-Deductible IRA Strategy

    Those taxpayers who can now contribute to a Roth IRA should contribute to a Roth IRA and not to a non-deductible IRA. Many taxpayers, however, are closed out of Roth or deductible IRA contributions because of participation in an employer’s qualified plan and/or being over an adjusted gross income limit. For them, maximizing annual non-deductible IRA contribution limits now makes sense no matter what their adjusted gross income levels.

    Any non-deductible traditional IRA after 2009 can be converted into a Roth IRA. As a result, the present $95,000/$150,000 AGI Roth contribution barriers will be ineffective. An individual with higher income need only first contribute to a non-deductible traditional IRA and then convert that amount into a Roth IRA.

    Even before 2010, those below the $100,000 AGI Roth conversion level can convert non-deductible traditional IRA accounts into Roth IRAs. For those above the $100,000 AGI level, 2010 is the start date for conversions.

    Rollover 401(k) Accounts

    Contributions to 401(k) plans cannot be rolled over directly into a Roth IRA. The lifting of the $100,000 adjusted gross income limit does not change this rule. However, 401(k) account balances often can be rolled over into a traditional IRA and then, after 2009, converted into a Roth IRA irrespective of adjusted gross income level.

    Most 401(k) plan participants cannot voluntarily pull out assets and roll them over into a traditional IRA. A plan amendment usually must permit it.

    Nevertheless, those growing ranks of 401(k) plan participants who are changing jobs or otherwise leaving employment can choose to roll over the balance into an IRA rather than elect to continue to have it managed in the 401(k) plan. Doing so will allow them to convert to a Roth IRA either before or after the 2010 date, depending on income level.

    Another option for current employee contributions is to amend the 401(k) plan to allow for Roth 401(k) accounts [see “New From Your Employer: The Roth 401(k) Plan” by Peter James Lingane in the January 2006 AAII Journal]. While those contributions are non-deductible, the effective tax is spread out each year and therefore is usually lower than waiting to do a Roth conversion transaction to cover several years all at once.

    Gather Those Old IRA Accounts

    Many taxpayers opened IRA accounts when they were first starting out in the work world and their incomes were low enough to contribute.

    Over the years, many have seen those account balances grow.

    These accounts now may be converted into Roth IRAs starting in 2010, regardless of income.

    Conversion Tax

    In spite of all the advantages of a Roth IRA, a conversion is generally advisable only if the taxpayer can pay the conversion tax out of proceeds other than from the account being converted. If the tax is paid out of a distribution from the converted IRA, that amount is not only taxed without the benefit of being placed in a tax-free account but it usually is also subject to an early withdrawal penalty tax of 10%.

    For those taxpayers considering a Roth conversion in 2010, plans to set aside other assets to pay the tax also should be made.

    Wild Cards

    Most plans carry uncertainties. Planning for a Roth conversion in 2010 is no exception.

    Congress might reconsider its generosity before 2010 and roll back some of the opportunities for Roth conversions.

    Capital gains rates might be lowered even further sometime in the future, making investments in non-deferred accounts more desirable.

    Income tax rates might rise and make paying the initial tax on conversion more onerous, either in 2010 or when income from 2010 conversions is otherwise averaged into 2011 and 2012.

    So far, however, prospects for overall tax savings by high-income taxpayers in converting traditional IRAs into Roth IRAs are sufficiently stable to point to a tax-saving course of action that should begin as soon as practicable.