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During 2006, there were
major legislative reforms involving taxes and pensions. The Tax Increase Prevention and
Reconciliation Act of 2005 (the “Tax Act”) extended several important tax
reduction provisions. The Pension
Protection Act of 2006 (the “Pension Act”) focused primarily on changes to
retirement plans. The
following is a brief summary of the major changes that have significant tax and
investment implications. For more
information on how NIPS can help with your taxes and investments, please contact
us at (407) 629-6477.
1.
Lower Capital Gains and Dividend Tax Rates Extended. The Tax Act extends the lower tax
rate on capital gains and qualified dividend income through the end of 2010. For taxpayers in the 10% or 15%
ordinary income tax bracket, the capital gain tax rate is 5% until 2008 and 0%
from 2008 to 2010. For those in
ordinary income tax brackets above 15%, the capital gains tax rate will stay at
15% until 2011. These tax reductions
were previously scheduled to expire in 2008.
Extending these lower tax
rates is great news for all long-term equity investors. To take advantage of these
historically low capital gains rates, investors may want to consider holding
investments that generate capital gains and dividend income outside of their
retirement accounts.
2.
Alternative Minimum Tax Partial Relief.
The Tax Act increased the exemption amount for AMT income to $42,500 for
individuals and $62,550 for married couples.
The exemption amounts are the amounts of AMT–taxable income taxpayers can
earn before they may be subject to AMT.
While this extension is important, it’s effect is limited to 2006 and
merely adjusts the previous exemptions for inflation. Consequently, those
taxpayers who were previously subject to AMT last year will most likely be
subject to it again this year.
3.
Roth IRA Conversions.
Currently, in order to convert a traditional IRA to a Roth IRA, taxpayers must
have an adjusted gross income of less than $100,000. Starting in 2010, Roth IRA
conversions will be available to all taxpayers regardless of income. However, conversions from a
Traditional IRA to a Roth IRA are treated as taxable distributions. Under the new law, those who convert
in 2010 can elect to pay the tax in two equal installments over the following
two years.
Investors should not be
persuaded by this opportunity to convert their IRAs to Roths. The conversion process is one that
increases tax revenue for the government and requires those who convert to pay
more taxes now. Investors should
always be looking for ways to reduce their current tax bill not increase it. This conversion option is simply a
way for the government to increase its revenue.
The Pension Act also
seeks to bolster government revenue for 2008 and beyond by allowing an
individual to rollover their company retirement plan directly to a Roth IRA. This removes a step from the current
process that requires a retirement plan to be rolled over to a traditional IRA
and then converted to a Roth IRA. By
removing a step in the current conversion process, the Pension Act again seeks
to encourage Roth conversions, which generate tax revenue for the federal
government.
4.
Higher Contribution Limits for IRAs and Retirement Plans. The Pension Act makes permanent
the higher contribution limits for IRAs, 401(k)s and 403(b)s that were
originally introduced in 2001. These
higher limits were previously scheduled to expire in 2010. For 2007, the annual IRA contribution
limit is $4,000 with a catch-up contribution of $1,000 allowed for those over
age 50. The 401(k)/403(b) limit is
$15,500 for 2007 with a maximum catch-up contribution of $5,000.
IRA contribution limits
will now adjust for inflation in $500 increments starting after 2008 when the
maximum contribution increases to $5,000 with a $1,000 catch-up contribution
permissible. 401(k)/403(b)
contribution limits will continue to increase by $500 per year. These continued
higher limits allow investors to save more for retirement while taking advantage
of the tax benefits of a retirement account.
The income limits that apply in determining whether traditional IRA
contributions are deductible or whether Roth contributions can be made are also
indexed to inflation under the new law.
Beginning in 2007, these limits will increase periodically for inflation
in $1,000 increments.
In addition, the Pension
Act allows for direct deposit of a taxpayer’s federal income tax refund into
their IRA starting in 2007. This
will allow more people to save for retirement with less effort.
5.
Tax
Credits for Retirement Accounts.
Current tax law provides a bonus to
eligible taxpayers for making contributions to retirements accounts. A tax credit of up to $1,000 per
person is available for married couples whose income is less than $50,000 and
individuals whose income is less than $25,000.
The credit applies to any type of retirement account and varies from 10%
to 50% of the first $2,000 contributed.
This tax credit was scheduled to expire at the end of 2006. The Pension Act makes this tax credit
permanent and indexes its income limits for inflation after 2006. This tax credit provides a tremendous
opportunity for those individuals just starting out in the work force to save
for their retirement and substantially lower their tax bill.
6.
Automatic Enrollment in 401(k) Plans.
The Pension Act embraced a number of
“auto-pilot” plan features.
Employees can be automatically enrolled at a fixed pre-tax salary deferral rate
when they meet the plan’s eligibility requirement. In addition, while not required, the
new law encourages minimum step-ups in the deferral rate. Employees must make an affirmative
election to opt out of these automatic enrollment features. Although these
provisions do not become effective until 2008, plan sponsors most likely will
implement these features sooner. These provisions serve to boost enrollment in
401(k) plans, especially among lower-paid and younger employees. This is particularly important in the
current environment where traditional defined benefit pension plan are becoming
extinct
7.
Broader Rollover Options. Starting
in 2007, non-spouse beneficiaries of a 401(k) or other retirement plan may roll
the distributions they receive to an inherited IRA. Previously, non-spouse beneficiaries
were not permitted to rollover such distributions and as a result, incurred an
immediate tax liability upon distribution.
These expanded rollover options allow non-spouse beneficiaries to stretch
out the distributions from a retirement plan over an extended period of time
rather than face an immediate tax bill.
However, if the monies
remain in the retirement plan, beneficiaries must draw down the accounts based
upon the particular parameters of the plan document and its administrator. In addition, an IRA provides greater
flexibility for tax withholding in contrast to the mandatory 20% withholding on
distributions from a retirement plan.
Consequently, investors still want to rollover their 401(k)/403(b)
accounts to an IRA when they leave their employer in order to preserve the
longest distribution schedule and maximum flexibility for their beneficiaries
8.
Required Minimum Distributors to Charities. The Pension Act makes it easier
to donate money directly from an IRA to a charity. The provision allows individuals who
are 70 ½ and older to take tax-free withdrawals so long as the distribution is
from an IRA and payable directly to a charity.
The maximum amount allowed is $100,000 and the opportunity exists only
for 2006 and 2007. These withdrawals
count against an individual’s required minimum distribution. Under current law, IRA withdrawals
are treated as part of taxable income.
If an individual directs the money to charity they can deduct the
contribution only if they itemize.
Under this new provision,
if the IRA withdrawal is donated directly to charity it is not included in
taxable income. Consequently, this
option will generally benefit those taxpayers who typically do not itemize. The provision will also benefit those
who may be subject to a phase out of their itemized deductions because of other
income.
9.
Permanent Tax-Free 529 College Savings Plans. Since 2002, withdrawals from 529
college savings plans for qualified education expenses have been tax-free. Previously, withdrawals of investment
earnings were taxed at the student’s individual tax rate. However, this tax-free exemption was
scheduled to expire in 2010. At that
time, withdrawals would have been once again taxed at the student’s individual
tax rate. The Pension Act makes
these tax-free rules permanent.
This legislative change
removes the largest uncertainty involving saving for college. Now, grandparents
and parents can save to educate their grandchildren and children without the
risk of tax law reverting to its old approach of taxing distributions at the
student’s rate. The 529 college
savings plans will now receive favorable tax-free treatment indefinitely.
For those employees who
don’t exercise control over their retirement plan, the default investment
options will provide a broader mix of asset classes rather than the traditional
money market option. Employers may now choose diversified portfolios for those
employees who are automatically enrolled but do not make their own investment
elections. This investment approach
better serves the employees rather than the traditional approach of using money
market securities which historically have been safe investments but have not
grown sufficiently to meet retirement needs.
In addition, plans that offer employee stock as an investment option must
meet certain diversification requirements.
Beginning in 2007, employees must be able to diversify their
contributions that are currently invested in employer stock if certain
requirements have been met.
The Pension Act provides
greater latitude to reservists and public safety employees (police and
firefighters) on distributions from their retirement accounts. Distributions to qualified
reservists, who were called up for active duty from September 1l, 2001 to
December 31, 2007, are not subject to the 10% premature distribution penalty
tax. In addition, they also
have up to two years after the end of their active duty to repay distributions
and avoid all income taxes.
Retirement plan distributions to public safety employees over age 50 who have
separated from service are also not subject to their 10% penalty tax. These provisions provide much greater
flexibility for retirement account distributions to reservists, police and
firefighters.
Breaking News on Recent Extension of Individual Tax Breaks
On December 9, 2006, the
last day of the 109th Congress, legislation passed by the House and
Senate renewed a variety of tax breaks.
These tax breaks had expired at the end of 2005 and lawmakers extended
them for two years beginning retroactively on January 1, 2006. First, the ability to deduct
qualified higher education expenses regardless of whether you itemize was
extended. This tuition deduction
allows for a maximum deduction of $4000 in tuition and fees for a married couple
with adjusted gross income less than $130,000.
Second, the opportunity to deduct sales tax as an alternative to state
income tax was extended. This is
particularly significant for
These tax breaks should
have been extended earlier in the year.
By waiting to the last possible day, Congress created an additional
governmental expense because the IRS had already mailed out the 1040 form and
instructions. Now, the IRS will need
to issue supplemental instructions regarding how and where taxpayers should
include these extended deductions on their 2006 federal tax returns. So much for tax simplification and
cost consciousness by our government!
In addition, taxpayers should also be aware of the
new tax credit that is available for certain energy efficient expenditures on
their personal residences. From 2006
to 2008, a lifetime credit of $500 ($200 for windows) is available for certain
qualifying materials. These include
installation of certain energy-efficient insulation materials, exterior windows
and doors, electric heat pumps and central air conditioning. The credit is 10% of the cost of
qualifying materials.
The legal and tax information contained herein is merely a summary of our understanding and interpretation of current tax laws as of December 15, 2006 and is not exhaustive.
Where indicated, past performance is not guarantee or
indication of future performance. Nelson Investment Planning Services, Inc. offers
securities through Nelson Ivest Brokerage Services, Inc., a member of NASD, MSRB and SIPC.
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