High-income taxpayers will find traps as well as opportunities in this year’s first round of tax legislation, recently signed by President Bush. There may be more to come. The Tax Increase Prevention and Reconciliation Act of 2005 (a curious name for legislation enacted in May 2006) extends the 15 percent maximum tax rate on capital gains and most dividends until 2010, two years beyond the prior expiration date. Beginning in 2010, the law also would allow better-off taxpayers to participate in Roth IRAs, which can provide significant tax advantages compared with traditional IRAs.
These future benefits are somewhat offset by an immediate tightening of the so-called “kiddie tax.” Under this rule, taxable income above $1,700 for certain minors is taxed at the parents’ typically higher marginal rate. From its enactment in 1986, the kiddie tax applied to taxpayers who had not reached age 14. But effective this year, with limited exceptions (mainly for minors who are married), the kiddie tax will apply to anyone who has not reached age 18 by Dec. 31.
Still to be decided, as Congress returned to work from its Memorial Day recess, was the fate of the estate tax. The tax currently applies to estates of more than $2 million, with the exemption scheduled to rise to $3.5 million in 2009 before the tax is eliminated in 2010 – but only for one year. Current law would restore the tax in 2011 with only a $1 million exemption. President Bush and many Republicans want to make repeal permanent. Most congressional Democrats and some Republicans want to preserve the tax, generally with an exemption higher than $1 million. As is often the case, this year’s tax legislation is being forged amid competing political and public policy goals that make predictions hazardous and some of the legislative outcomes somewhat odd.
Roth IRAs are a case in point. Since enactment in the late 1990s, Roth plans have allowed taxpayers to make nondeductible retirement contributions whose earnings can later be distributed tax-free. This is often more favorable than the traditional IRA approach, which provides an up-front deduction for many contributors but whose later distributions usually are subject to income taxes. Another advantage of Roths is that taxpayers over 701/2 are not required to take mandatory minimum distributions, as required for regular IRAs.
Only taxpayers with incomes below $110,000 for individuals and $160,000 for joint filers are currently allowed to make Roth IRA contributions, and only taxpayers with incomes below $100,000 are allowed to convert existing IRA accounts to Roth plans. But under the newly signed legislation, those income restrictions will be removed beginning in 2010. The law provides an additional break by permitting taxpayers who convert existing IRAs to Roth plans in 2010 to defer paying taxes on the conversion until 2011, when the first half of those taxes will be due, and 2012 for the balance.
Those tax collections will help the government’s cash flow in the short term. Critics of the relaxed Roth rules argue that in later years, beyond the current revenue scorekeeping, the Treasury will sacrifice far more than it received. But taxpayers seeking to take advantage of the Roth regime should at least consider the possibility that some future Congress, perhaps under pressure to plug holes in Medicare and Social Security finances, may abruptly change the rules again to make Roths less favorable.
That is essentially what happened with the kiddie tax. Many taxpayers use Series EE Savings Bonds, which allow taxes on interest to be deferred until the bonds are cashed, to save for youngsters’ education. A typical plan is to cash such bonds when a student reaches her mid-teens, at a point when she is entitled to be taxed at her own bracket rather than that of her parents, but before any college jobs or summer internships begin generating income.
With no warning, the new law imposed the kiddie tax on most teens up to age 18, a point at which independent work is more likely (though perhaps still not all that likely) to result in a higher tax bracket. Anyone who cashed savings bonds or triggered other income earlier this year, before the legislation was enacted, is still subject to the new provisions. Despite the uncertainties, it makes sense to plan for the new law’s provisions as well as the possibility of future legislation. For example, a high-income taxpayer who leaves a job with a hefty 401(k) balance might want to roll over that balance to a regular IRA, in order to then be able to convert the regular IRA to a Roth in 2010. Conversions directly from 401(k)s or other qualified plans are not allowed. Likewise, teenagers who are in a position to do so might want to defer recognizing taxable income until after they reach age 18, since most teens still would be in a low tax bracket at that point.
On the estate tax front, taxpayers and professionals alike have been wrestling since 2001 with the knowledge that the one-year elimination, followed by reinstatement at a $1 million exemption level, is unlikely to actually happen — but nobody knows what will happen instead. With Republicans divided into pro-repeal and anti-deficit factions, and Democrats solidly in favor of keeping some form of the estate tax, we will have to wait to see whether any legislation emerges from the current Congress (perhaps in a postelection lame-duck session) or whether the legislative guessing game will extend into 2007.
EDITOR’S NOTE: Tim Bliss, a senior at New York University Stern School of Business, is a summer intern at Palisades Hudson Financial Group LLC.