Improving Your Retirement: How Two New Tax Laws Will Affect Your Bottom Line

If you've seen any accountants jumping for joy recently, it's probably because two major laws have been passed this year that shake up the rules for all kinds of personal finance planning
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If you've seen any accountants (or financial planners) jumping for joy recently, it's probably because two major laws have been passed this year that shake up the rules for all kinds of personal finance planning.

-The Tax Increase Prevention and Reconciliation Act of 2005

Passed in May 2006, this new law establishes a higher AMT exemption, extends the 15 percent capital gains and dividend rate (5 percent if you're in the lower tax brackets), allows anyone to convert to a Roth IRA in 2010 and beyond, and raises the age limit for "kiddie tax" to 18.

Now let's figure out what that really means.

-AMT

Alternative minimum tax (AMT) is a thorn in many people's sides. Although initially enacted to make sure the rich paid their fair share of taxes, these days AMT hits a lot of middle-class taxpayers, too.

The new law will raise the exemption amount to $62,550 for married filing jointly (up from $58,000) and $42,500 for single taxpayers (up from $40,250).
But only for 2006.

You read that right. This AMT increased exemption amount is for one year only. These increases are small and will have minimal impact on most planning. No real solutions here.

-Capital Gains and Dividends

The lower capital gains tax and tax on certain qualified dividends were scheduled to expire at the end of 2008. The new law will extend that through 2010. That means that if you're in the 10 percent or 15 percent ordinary income tax bracket, you'll pay 5 percent on capital gains from now until 2008 and 0 percent from 2008-10. For those people in ordinary income tax brackets above 15 percent, the capital gains tax rate will stay at 15 percent until 2011.

That will present some interesting planning opportunities for transferring wealth to individuals in lower tax brackets. Parents may be able to gift appreciated stocks to their children or grandchildren who will then be able to sell the securities and pay a much lower capital gains tax. This also reduces parents' or grandparents' overall estate, which may be beneficial from an estate tax standpoint.

At this point, it looks like these rates will go back to 20 percent for capital gains and as high as 39.1 percent on dividends in 2011. If you're doing future planning, you'll want to make sure you keep these higher rates in mind. If you think that taxes will increase in the future, you may want to sell securities sooner rather than later to take advantage of the fairly benign capital gains rates now. (Of course, there are bound to be more tax law changes between now and 2011.)

-Roth IRA Conversions

A number of my clients have been using Roth IRA conversions as a way to reduce their minimum distribution requirement when they turn age 70 1/2. One of the barriers we run into is that you can't convert unless your adjusted gross income (AGI) is $100,000 or less. The new tax law will eliminate that income threshold so that anyone can do a Roth conversion.

But not until 2010. At that point in time, you'll be able to recognize the conversion income either in 2010 or average it over two years.

This is big.

If ordinary income tax rates do go up in 2011 as scheduled, a lot of people will want to take advantage of converting in 2010. Even if your income is over $100,000 now, you can make nondeductible contributions to a traditional IRA and then convert the entire balance in 2010.

-Kiddie Tax

"Kiddie tax" refers to the tax that is owed on unearned income (like interest and dividends) of a minor child. Currently, if a child is under age 14, the first $850 is tax exempt, the next $850 is taxed at the child's rate, and anything above $1,700 is taxed at the parents' rate. Under the old law, once children were 14 and older, they paid income tax at their own lower rates.

The new tax law pushes up the age to 18. So net unearned income above $1,700 will stay taxable at the parents' rate until the child is 18.

This will affect a lot of you who are saving for your children's college education. (But keep in mind that it affects you only if your child's portfolio is kicking off more than $1,700 in income per year.) Typically you shift stock types of investments to fixed income the closer the child gets to starting college. You do that so your college nest egg is more secure. But fixed-income types of investments will usually generate more income that will now be taxed at a higher rate.

-The Pension Protection Act of 2006

The latest tax law was passed in August and covers 529 plans, charitable contributions, and--you might have guessed it--pensions. Actually more than just pensions; it also covers all kinds of retirement-related issues.

-529 Plans

The tax benefits of 529 plans are no longer scheduled to disappear after 2010. So if the "sunset" issue was preventing you from using a 529 plan to save for your child's or grandchild's college education, cross that off the list.

-Charitable Donations

The pension-reform bill contains a couple of interesting new provisions that affect charitable giving. First, if you don't have written documentation for any cash gift, you can't claim a deduction. So for you church-goers, gone are the days you can throw $20 in the offering plate and claim it on your taxes. You'll need to use your offering envelopes (or whatever your house of worship uses to document offerings), or you can't write it off.
And there's good news for you seniors over age 70 1/2. You can give up to $100,000 in 2006 and 2007 directly from your IRA to a qualified charity. (You can do this with your required minimum distribution.) That money will not be counted as taxable income.
There are a few caveats with this last charitable strategy:

Nobody under the age of 70 1/2 can take advantage of these new IRA giving rules.
While the law permits you to give to charity directly from your IRA, it doesn't require IRA administrators to accommodate your request. You may see some IRA providers balking at making millions of $10 and $20 gifts.

Because the gift isn't counted as income, it won't matter if you itemize deductions on your tax return.

Gifts must be from traditional or Roth IRAs--not 401(k)s, 403(b)s, or other types of defined contribution plans, and not SEP or SIMPLE plans. You can, however, roll part or all of your 401(k) plan (or other company retirement plan) into a traditional IRA and then do your gifting. (See below for new rules on transferring money directly from your 401(k) or company retirement plan directly to Roth IRAs.)

The money must come out of the IRA directly to the charity or you have to declare it as ordinary income. Don't write a check to yourself and then gift the money.

The charity must be a public charity or private foundation. This won't work with donor-advised funds.

Qualifying IRA contributions to charity will affect only pretax contributions. If you've made nondeductible contributions, your cost basis will remain intact.

-IRA Contributions from Tax Refunds

If you find yourself with a tax refund, you'll now be able to direct the IRS to deposit up to $4,000 ($5,000 if you're over age 50) directly into your IRA account.

-Rolling to an IRA

The Pension Protection Act makes two important changes to rollover rules. For the first time ever, in 2007 and beyond, a nonspouse beneficiary will be able to directly roll over a deceased benefactor's retirement plan, like a 401(k), into an inherited IRA. This inherited IRA will need to be opened in the name of the deceased and payable to the beneficiary.
This is good news for any beneficiary who inherited a retirement plan which would allow for distributions only over a five-year period. With the new law, required minimum distributions for the beneficiary can stretch over the beneficiary's lifetime-extending the tax-deferral advantage.

Just keep in mind that the direct rollover starts only in 2007. So if you are a beneficiary, try to defer taking a distribution until next year.

A second major change to the rollover rules is that effective in 2008, you will be able to roll over your company retirement plan (like a 401(k)) directly to a Roth IRA. Right now you have to roll your company retirement plan proceeds into a traditional IRA and then convert. This new law skips that middle step and allows you to go directly to a Roth.
One caveat: You still must have AGI (adjusted gross income) of less than $100,000 to convert to a Roth until the year 2010.

-Company Retirement Plans

There are several new twists and turns that apply to your company retirement plans. Let's start by separating these plans into two groups: defined-contribution and defined-benefit plans.

Defined-contribution plans include 401(k)s, 403(b)s, 457s, and other like plans. You, as the participant, make contributions into these accounts and basically you're on your own to make sure you save enough for your "golden years." Here's what changes under the new tax law:

Plans can "auto-enroll" you in the company retirement plan without your initial consent. Instead of choosing to participate, you'll choose to opt out if you don't want to participate. The company will choose a default investment that you may be automatically invested in unless you say something.

Plans can offer computerized investment advice to participants. This law makes it much easier for plan providers to give participants advice. The law also has provisions to make sure the advisors offering the investment options can't make more money selling one fund over another.

Plans have to offer more financial education to make sure plan participants know the tax ramifications of taking money from their plans.

Military and some public service people may be able to take distributions from their company retirement plans without incurring a penalty. This applies to those active military reservists from Sept. 11, 2001, to Dec. 31, 2007. The law gives them two years after the end of their active duty to repay distributions and avoid taxes and penalties. Certain retired public safety officers can withdraw retirement funds without penalty for health or long-term care premiums up to $3,000 a year.

Lots of retirement contribution amounts are now permanent and won't change after 2010. This includes 401(k)s (and similar plans), IRAs, SIMPLEs, and catch-up contributions for each type of plan.

The Roth 401(k) plan is now permanent. That means more employers may start offering them.

The other type of retirement plan, a defined-benefit plan, also changes under the new tax law. A defined-benefit plan is one in which the employer puts money into a plan to pay you a pension at retirement. Pensions are typically based on years of service and final average salary. Here are some of the relevant portions of the new tax law that affect these plans:

There will be tighter controls to make sure that pension plans fund these accounts so that less plans will declare bankruptcy and force the Pension Benefit Guaranty Corporation (PBGC) to clean up the mess.

Most companies are given the next seven years to comply with the new law, but the airline industry and defense contractors are given special breaks.

The new law requires that companies meet 100 percent of their pension funding requirements each year-up from 90 percent. There's a 10 percent excise tax for funding deficiencies.

For those plans that have met 60 percent or less of their funding requirement, all lump-sum payments and nonqualified plan payouts may be suspended.

Companies will have to pay higher premiums to the PBGC to help offset the cost of bailing out failed plans.

This is the most comprehensive pension reform we've seen in over 30 years. You can bet we'll be writing a lot more about these changes as we have a chance to think through all the financial-planning ramifications.

** Please Consult your Tax Advisor **