Summary of the Tax Increase Prevention and Reconciliation Act
On May 11, 2006, the Senate passed the long awaited Tax Increase Prevention and Reconciliation Act (H.R. 4297) (The Act), a $70 billion tax cut reconciliation bill authorized by last year’s budget resolution. President Bush signed the bill into law on May 17, 2006. The primary focus of the Act is to extend several tax breaks that expired in 2005 or are scheduled for expiration in future years while providing various revenue producing provisions that intend to comply with the specific requirements of the budget process.
Capital Gains and Dividends
The Act extends the current preferential rates that apply to certain dividend and long-term capital gains, which were scheduled to expire beginning in 2008 through 2010. Under the Act, long-term capital gains and dividends paid by domestic and qualifying foreign corporations will continue to be taxed at 15 percent for individuals with income in the top four brackets through 2010. For taxpayers with taxable income in the lowest two brackets, the same income will be taxed at 5 percent through 2007, and at zero percent from 2008 through 2010. These rates apply for both regular and Alternative Minimum Tax (AMT) purposes. Rates for collectibles and unrecaptured real estate depreciation remain the same at 28 percent and 25 percent, respectively.The Act extends the current preferential rates that apply to certain dividend and long-term capital gains, which were scheduled to expire beginning in 2008 through 2010. Under the Act, long-term capital gains and dividends paid by domestic and qualifying foreign corporations will continue to be taxed at 15 percent for individuals with income in the top four brackets through 2010. For taxpayers with taxable income in the lowest two brackets, the same income will be taxed at 5 percent through 2007, and at zero percent from 2008 through 2010. These rates apply for both regular and Alternative Minimum Tax (AMT) purposes. Rates for collectibles and unrecaptured real estate depreciation remain the same at 28 percent and 25 percent, respectively.
Alternative Minimum Tax Relief
When the AMT was enacted in 1969, it was originally designed to safeguard against the “very wealthy” exploiting certain tax incentives to avoid paying income tax. However, the number of taxpayers subject to AMT has escalated dramatically and is predicted to further increase in the next decade. Taxpayers who may be particularly vulnerable to the AMT are those living in states with high state and local income taxes (such as California, New York, Montana, Oregon and Vermont), high property taxes (such as New York, Illinois and New Jersey) and deductible personal exemptions. Other taxpayers who could be subject to the AMT include taxpayers with large long-term capital gains or qualified dividends, large miscellaneous deductions, large deductions for accelerated depreciation and taxpayers who have exercised incentive stock options (the bargain element of an incentive stock option is not subject to ordinary income tax when exercised, but is subject to AMT).
In an effort to stabilize the growth of AMT for another year, the Act increases the AMT exemption amount for taxpayers in 2006. For 2006, the AMT exemption amount for married taxpayers increases to $62,550 and for unmarried individuals to $42,500. The exemptions were $58,000 and $40,250, respectively, for the same taxpayers in 2005, and would have dropped to $45,000 and $33,370 without the change. In addition, the Act extends through 2006 the ability for individuals to apply certain nonrefundable personal tax credits (e.g., credits for dependent care, the elderly and disabled, Hope Scholarship and Lifetime Learning, and D.C. homebuyers) against regular tax and AMT.
Clearly, the AMT relief offered by the Act is only temporary. If Congress fails to either extend the relief beyond 2006 or develop a more permanent solution, such as permanent repeal, increasing or indexing the exemption, or modifying the AMT tax base, taxpayers again will face an overly broad application of AMT in 2007.
Roth IRA Conversions
Like a traditional IRA, a Roth IRA provides a taxpayer the opportunity to contribute to a tax-deferred retirement account. Unlike a traditional IRA, however, contributions to Roth IRAs are not deductible for income tax purposes, but qualified withdrawals are generally free of federal income tax. Despite the loss of the up-front income tax deduction, since the amounts contributed to a Roth IRA grow income tax-free, they are a good retirement planning option for those who qualify.
To take advantage of the benefits of a Roth IRA – which in addition to tax-free earnings also include the option of making additional contributions to the account after age 70-1/2 and the avoidance of the mandatory distribution rules applicable to traditional IRAs – a taxpayer may want to consider converting a traditional IRA to a Roth IRA. Although the conversion will result in immediate tax recognition, the added benefits of a Roth IRA may make this a useful wealth transfer vehicle.
Under current law, only individuals with modified adjusted gross income below $100,000 (excluding any minimum required distribution amounts received by the individual from traditional IRAs) may convert their traditional IRAs to Roth IRAs. Beginning in 2010, the Act removes the $100,000 income limitation and allows taxpayers with higher incomes to take advantage of the conversion without penalty. In addition, if the conversion occurs in 2010, the Act permits a taxpayer to spread the income recognition ratably over 2011 and 2012 to ameliorate the tax impact of the conversion. Thus, the amount of taxable income from a 2010 conversion is not includible in gross income until 2011 and 2012. However, income inclusion is accelerated if the converted amounts are withdrawn from the Roth IRA before 2012.
This change provided by the Act is touted as an opportunity for taxpayers, as well as a revenue boost for the government. The conversion opportunity is effective for taxable years beginning after December 31, 2009, and is expected to raise $6.43 billion in tax revenue over 10 years.
Other Revenue Producing Provisions of the Act
In addition to the revenue boost projected with regard to the change in the Roth IRA conversion provisions, the Act contains several other compliance changes that are intended to increase government revenues to meet budget concerns. The revenue producing provisions are mainly focused on compliance measures, including withholding on payments to government contractors and substantive tax increases, such as restrictions on the housing exclusion available for Americans working abroad.
From an individual taxpayer’s perspective, the most notable of the revenue producing provisions is the increase in the age below which investment income of minors is taxed as if it were earned by the parent (the so-called “kiddie tax”). The Act extends the age of children to whom the kiddie tax applies from children under age 14 to those under age 18, unless the child is married and files a joint return. The provision applies to taxable years beginning after December 31, 2005.
The short-term extension of previous tax benefits without any permanent reform suggests that Congress is not prepared to make significant changes to the tax system presently. By enacting the Tax Increase Prevention and Reconciliation Act, Congress postponed the decision of whether or not to make permanent the following: (1) the preferential capital gains and dividends rate; (2) the lower ordinary income tax rates; (3) the marriage penalty relief; and (4) the child credit. It is also important to note that the Act failed to address estate tax repeal or reformation.