Legislative Update Congress has recently passed a bill entitled the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), which would extend a number of tax breaks that are either scheduled to expire this year or have already expired.  President Bush signed this act on May 17, 2006.  The most important of these provisions are a one-year extension of the expanded alternative minimum tax (AMT) exemption and a two-year extension of favorable tax rates for qualified dividends and long-term capital gains.  TIPRA would also allow businesses to continue taking expanded write-offs for capital purchases such as equipment and allow certain personal tax credits to be applied to AMT liability. AMT Relief The AMT is a separate tax calculation from the one on Form 1040.  It eliminates many of the well-known deductions such as the exemption for taxpayers and their dependents, the deduction for state and local taxes, and some of the medical expense deduction, among others.  The AMT replaces all of these disallowed deductions with a single exemption and forces taxpayers to pay the higher of the two tax calculations. For 2006, the AMT exemption amount has been increased to $62,550 for joint filers and $42,500 for single filers.  If Congress had not passed this legislation, the exemption amount for joint filers would have dropped to $45,000 and an estimated 15 million additional taxpayers would have been subject to this tax. To pay for these tax breaks, Congress had to include a number of provisions that would increase revenues during the same period.  One waives the income limits on conversions of traditional IRAs to Roth IRAs (the current cutoff is adjusted gross income of $100,000) beginning in 2010, which will make the funds taxable at the time of the conversion and tax free upon distribution.  Congress also increased the amounts taxpayers will have to pay when submitting an offer in compromise - up to 20 percent of the offer in the case of lump sum offers.  Tax Trap Alert! Another section of the law increases the age limit for the "kiddie tax" from 14 to 18, effective January 1, 2006.  When a child has net unearned income, including interest, dividends and capital gains, in excess of the threshold amount (currently $1700), that income is taxed at the parents' rate.  This is a significant detail for many of our clients who have children in or approaching their teen years and came as something of a surprise.  If your child may be subject to this tax, please consult with your financial advisor for investment strategies that can help you minimize the negative effects of the new law.  Several favored provisions did not make it into the final version of TIPRA, including extension of the tuition and fees deduction for higher education expenses, a continued deduction for state and local sales taxes, 15-year straight-line depreciation for restaurant and leasehold improvements, and a charitable deduction for taxpayers who dot not itemize deductions.  It is likely that some of these items will make it into proposed pension legislation, which is currently being discussed in congressional committees. Tax Law Changes for 2006 A number of changes are set to take effect for the 2006 Tax Year.  These include some tax breaks and incentives from last summer's energy legislation, increased Section 179 expensing amounts, different calculations for the personal and dependency exemptions and itemized deductions for higher-income taxpayers, and a new way to fund tax-free retirement income. Section 179 Deduction To encourage capital investment among small businesses, in 2003 Congress increased the value of capital purchases that can be expensed in the year of the purchase from $24,000 to $100,000, when total purchases do not exceed $400,000.  This limitation is indexed for inflation, and is $108,000 for total purchases not exceeding $430,000 for 2006.  The higher limits were due to expire in 2008, but have been extended to 2010 under the new law. 2005 Energy Act Provisions Last summer's long-delayed energy legislation contained a number of tax incentives available to both businesses and individuals.  One of the biggest changes for individuals is a new tax credit for the purchase of certain qualified clean fuel vehicles, including hybrids and electric automobiles.  Tax credits are also available for purchases such as insulation and certified energy-efficient windows, water heaters and heating and cooling systems, solar energy sources and fuel cell technology.  Credits are also available for energy-efficient construction and improvements to business property. Alternate-Fuel Vehicles - Until this year, purchasers of new hybrid and electric vehicles could take a deduction of $2,000.  TIPRA changes this to a tax credit that varies in amount depending on the type of vehicle purchased.  Estimates of the credits range from $250 for the Chevy Silverado hybrid models to $3,150 for the Toyota Prius.  Although hybrid vehicles are generally several thousand dollars more expensive than their gasoline-only counterparts, this credit could become extremely popular if gas prices remain at or above the $3 per gallon range. Important Note:  Credits offer much larger tax breaks than deductions of a similar amount.  A credit is a dollar-for-dollar reduction in taxes, but the tax savings from a deduction is only the amount of the deduction times the taxpayer's highest tax rate.  A $2,000 deduction reduces the tax liability of a taxpayer in the 25 percent bracket by $500, but a $2,000 credit reduces the liability by $2000, making it worth the same as a deduction of $8,000 to that same taxpayer. However, the amount of the credit is reduced beginning in the quarter after the vehicle's manufacturer has sold 60,000 hybrid vehicles.  Toyota, which also makes Lexus automobiles, expects to reach that figure this calendar quarter.  President Bush has urged the repeal of the phaseout provision to encourage more hybrid purchases, so stay tuned! Energy Improvement Credits - Taxpayers can also receive a credit equal to 10 percent of the cost of qualified energy efficiency improvements, which includes exterior doors and windows, insulation, and furnaces.  The credit is limited to $500 total for 2006 and 2007, and there are limitations based on the type of improvement.  No more than $200 of the credit may be for windows; qualified natural gas, propane and oil furnaces are limited to a credit of $150; up to $50 of the credit may be for advanced main air circulating fans; and a maximum of $300 of the credit may be for energy-efficient building property. In addition, there is a 30 percent credit for the installation of solar water heaters (not including those used even in part for hot tubs and swimming pools), solar electricity equipment and fuel cell plants.  The maximum amount of the credit is $500 for each half kilowatt of fuel cell plant capacity and $2,000 for each category of solar equipment.  Both consumer credits are available only for property installed in a principal residence. Phaseouts Phased Out Another change in the works for 2006 is a reduction in the personal and dependent exemption and itemized deduction phaseout amounts.  Since 1990, higher-income taxpayers have been paying a hidden tax in the form of a phaseout of their personal and itemized deductions.  In tax years through 2005, this meant a 2 percent reduction in the personal exemption and a 3 percent reduction in itemized deductions for every $2,500 in income above the threshold amount.  These phaseouts will be eliminated in equal portions over three years and will be off the books for 2008 - good news for some filers! The bad news for taxpayers at these income levels is that the AMT wipes out personal and dependency exemptions entirely and takes back certain kinds of itemized deductions.  Many taxpayers who might otherwise benefit from the elimination of these phaseouts will not see a reduction in their taxes due to the AMT.  Unless Congress repeals the AMT, which isn't an option currently on the table in Washington, many taxpayers will not see the effects of the elimination of the phaseouts.  (Sometimes, all that glitters is not gold.) Now Available: the Roth 401(k) In 2002, the first round of tax cuts contained a provision allowing for an alternate method of funding retirement through 401(k) and 403(b) plans.  However, Congress delayed its effective date until 2006.  In traditional 401(k) and 403(b) plans, contributions are excluded from your gross income until you withdraw the funds from your plan.  As the name suggests, with a Roth 401(k), you would pay taxes on the money you contribute to the plan.  When the funds are withdrawn in a qualifying distribution, the income is tax free, just as with a Roth IRA. There are several reasons why a Roth 401(k) is superior to a Roth IRA.  One is that unlike the Roth IRA, the Roth 401(k) permits contributions at all income levels - just like the traditional 401(k).  If your adjusted gross income exceeds $100,000 or you are married but filing separately, you would not be able to contribute to a Roth IRA.  Another reason is that the contribution limits are much higher.  Roth IRA contributions are limited to $4,000 per year ($5,000 for taxpayers over 50), but contributions to 401(k) plans are allowed up to $15,000 ($20,000 for taxpayers over 50).  Since the maximum contribution limits are the same for both types of plans, the Roth contribution is much more valuable.  A $20,000 Roth contribution is the equivalent of a $33,333 deductible contribution to someone whose earnings are taxed at a total rate of 40 percent.  For participants who have a relatively long period before retirement, the value of tax-free earnings can be substantial. Several caveats apply to these plans: First, the employer must make Roth 401(k) plans available by amending their plan documents to permit non-deductible contributions. Second, the contribution limits apply to all 401(k) contributions, so the actual limitation for contributions to Roth 401(k)s is the total limit minus amounts contributed to traditional plans. Third, there is a period lasting five years from the beginning of the first tax year in which contributions are made during which distributions are not entitled to tax-exempt treatment, regardless of whether the plan participant has reached age 59 ½, just as with a Roth IRA.  Fourth, conversions of existing 401(k) plans to Roth plans are not permitted. Fifth, employer matching contributions may not be treated as Roth contributions and are taxable on distribution. Finally, Roth 401(k) plans are subject to the same rules requiring minimum distributions at age 70 ½ as traditional plans, unlike Roth IRAs.  An excellent wealth management strategy is to roll your Roth 401(k) into a Roth IRA.  This would eliminate the need for minimum distributions and allow you to withdraw the money when you want or even leave it to family members.  Please see an attorney specializing in trusts and estates for the best way to pass IRA assets on to your loved ones. There are instances when a traditional 401(k) plan can be the better alternative.  Which plan is right for you depends on a thorough analysis of your financial plans and circumstances.  You should consult with your financial planner or a tax consultant here at Zimmerman, Boltz & Company to help determine which plan is right for your situation.