$70 Billion Tax Cut Package Becomes Law

A $70 billion tax cut package, the Tax Increase Prevention and Reconciliation Act (TIPRA), became law on May 17, 2006. At the center of this legislation is the extension of lower long-term capital gains and dividend rates through 2010. In addition, this measure provides AMT relief and extends the more generous Section 179 expensing limits for business owners. To balance these tax breaks with revenue-raising provisions, this bill applies the "kiddie tax" to children under age 18 instead of age 14, effective immediately, and permits higher-income taxpayers to convert traditional IRAs to Roth IRAs, beginning in 2010.

Good News for Investors

TIPRA extends the 15% tax rates on long-term capital gains and qualified dividends through 2010. Put in place by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), these reduced rates had been due to expire at the end of 2008. Taxpayers in the 10% and 15% income tax brackets pay 5% through 2008, and then zero tax on long-term gains from 2008 through 2010. Prior to the enactment of JGTRRA, the top rate for long-term capital gains was 20%, while dividends were taxed as ordinary income at a maximum rate of 35%.

AMT Relief

This legislation also raises the 2006 AMT exemption amounts to $62,550 for married couples filing jointly and $42,500 for single filers. If no congressional action had been taken, the exemptions for the 2006 tax year would have fallen to $45,000 for joint filers and $33,750 for individuals. Under the new law, taxpayers may use all nonrefundable personal credits to offset AMT liability.

A parallel tax system, the AMT typically applies to families taking large numbers of deductions. According to the Urban-Brookings Tax Policy Center, 3.6 million filers paid the AMT in 2005, but 18.9 million taxpayers would have been hit with the AMT in 2006 without additional relief.

Extended Section 179 Expensing

TIPRA extends through 2009 the favorable Section 179 expensing limits established by the Jobs and Growth Tax Relief Reconciliation Act of 2003. Section 179 expensing allows business owners to take an upfront deduction on qualified equipment purchases, including off-the-shelf computer software. Under JGTRRA, the expense limits quadrupled from $25,000 to $100,000, and this higher amount is indexed for inflation each year. In 2006, business owners can write off up to $108,000 of qualifying purchases. The deduction is reduced dollar for dollar if you buy more than $430,000, and if your purchases exceed $538,000, the remainder must be depreciated. Without TIPRA reform, the expensing limit would have dropped back to $25,000 in 2008 with a phaseout threshold of $200,000.

Expanding the Kiddie Tax

The law also raises the age limit for the "kiddie tax" from 14 to 18 years of age. These new rules take effect in 2006. Unearned income, such as dividends and interest, exceeding $1,700 for children under age 18 will now be taxed at the parents' top rates, unless the child is married and files a joint return. Prior law applied the kiddie tax to children under age 14. This allowed children 14 and older to pay taxes on their investment income at rates most likely lower than their parents' top rates. An exception applies to distributions from qualified special needs trusts.

Roth IRA Conversions

TIPRA also eliminates, starting in 2010, the current $100,000 adjusted gross income (AGI) ceiling on converting traditional IRAs to Roth IRAs. Funded with after-tax dollars, Roth IRAs offer tax-free earnings and tax-free distributions, provided you have reached age 59½ and have owned the account for five years when you make withdrawals. Unlike traditional IRAs, Roth IRAs have no minimum distribution requirements at age 70½.

Conversions are treated as distributions; therefore, income tax will be due, but funds will not be penalized for early withdrawal. Critics of the tax package point out that the estimated $6.4 billion in tax revenues resulting from conversions of traditional IRAs to Roth IRAs will be cancelled out as withdrawals from Roth IRAs escape taxation over the coming decades.

Given the temporary nature of this latest reform and the possibility of further changes on the horizon, it is important to regularly review your tax and financial strategies.