Now you can map out your investments

01:01 PM EDT on Monday, May 22, 2006

By PAMELA YIP / The Dallas Morning News

Congress and President Bush have given taxpayers a little more certainty in planning their finances.

Randy Mack Bishop / DMN

Mr. Bush last week signed into law a $70 billion tax-cut package that Republicans hope will attract votes as they head into midterm elections with worries about holding on to control of Congress.

The hallmark of the tax relief act is a two-year extension of the reduced 15 percent tax rate for capital gains and dividends. The cut was to expire at the end of 2008 but has been extended to 2010.

"No recent tax cut has been as controversial as the dividend and capital gains tax rate cut enacted in 2003," said tax analysts at CCH, which publishes tax information and software. "While the White House and Republicans credit this tax cut with spurring economic growth, Democrats decry it as a giveaway to the wealthy."

Whatever their politics, it behooves every taxpayer to get the most out of the new law.

The law also protects more Americans from the alternative minimum tax and lifts the income limit on Roth IRA conversions. But it expands the "kiddie tax" to prevent parents from using their children's lower income tax rate to shelter investment income.

Lower rate on dividends and capital gains extended, but loophole on kids tightened

Investors should enjoy the 15 percent tax rate on capital gains and dividends while they can. The tax cuts were never meant to be permanent, and if Republicans lose control of Congress, any more extensions would seem unlikely.

The Tax Relief Extension Reconciliation Act of 2005 has extended the cuts through 2010. The law also protects more Americans from the alternative minimum tax, lifts the income limit on Roth IRA conversions, and says minors' income has to be taxed at their parents' rate.

Capital gains, dividends

Not all capital gains and dividends qualify for the lower 15 percent tax rate.

For example, capital gains from the sale of collectibles, such as antiques or paintings, don't qualify for the lower capital gains rate. Instead, they're subject to a top rate of 28 percent.

What's more, to qualify for the lower tax rate, the dividends must have been paid by a U.S. corporation or a qualified foreign corporation and must meet other conditions.

"The best part of the new tax law is the extension of the 15 percent rate on capital gains and dividends to 2010," said John Eads, a certified public accountant and partner at Smith, Jackson, Boyer and Bovard in Dallas. "The extension could allow lower bracket taxpayers to recognize long-term capital gains and qualifying dividends with no tax."

For example, a parent could give his child who's in a lower tax bracket a stock that's risen in value.

The rub there is to make sure that the value of the stock is under the $12,000 annual gift-tax exclusion to avoid gift tax.

The gift-tax exclusion means you can give away as much as $12,000 this year to anyone you wish — and to as many people you wish — without having to report it to the Internal Revenue Service. There is no limit on the total amount you can distribute.

"With the proper planning on the amount of the gifts made, the children could possibly sell the appreciated property and maximize the benefit of the zero capital gains tax in 2008, 2009 and 2010," Mr. Eads said.

The current 5 percent capital gains rate for low-income taxpayers will drop to zero in 2008.

'Kiddie tax'

But what Uncle Sam gives, he can also take away, and one part of the tax bill can wipe out the benefits of the tax cuts.

The tax law raises the age limit of the so-called "kiddie tax," which subjects a child's income to the parent or parents' higher tax rate. This provision, which takes effect immediately for all of 2006, applies only to unearned income.

Under the old law, a child 14 and older can file a separate income-tax return and pay tax at a lower children's rate. But under the new law, the child's income is taxable at the parent's higher rate until the child turns 18.

"This provision tightens a loophole used to shelter investment income," said a U.S. Senate Finance Committee summary of the tax bill provisions.

"Some of the advantages of the capital gains [tax cut] may be negated by the kiddie tax," Mr. Eads said. "What you're hoping is that you would hold out until the kid reaches 19 before you take the capital gains."

But you have no idea how stocks will perform in the future, and you don't necessarily want your investment decisions to be dictated by tax policy.

"If I had planned to shift assets producing dividends and interest to my children [over the age of 14] through the gift-tax exclusion to possibly provide college costs at my child's lower tax bracket, I am not going to be able to do that under the new provision," Mr. Eads said. "I can maybe dodge the bullet by putting the money I would have transferred to my children into a 529 college saving plan or possibly placing investments to earn capital gains/dividends in their name through some mutual fund to try to avoid the tax at the parent level."

Financial advisers said clients should consider options, such as 529 college savings accounts. That's because interest, dividends and capital gains on contributions to those accounts generally escape taxes if the money is used for college bills.

Some care is needed here, because how you structure your savings for college can affect your child's ability to receive financial aid.

"If the child owns the 529 account, then it's not included in eligibility," said Joseph Hurley, founder of Savingforcollege.com, a college-financing information Web site. "If the parent owns the account, then it is counted as a parent asset, and it hurts a little bit."

If you save for college in a pure mutual fund, and the account is the child's name, "that hurts a lot because it's treated as a student asset," Mr. Hurley said. "If you keep it in the parent's name, it hurts a little."

Another strategy to get around the kiddie tax is to avoid investments that generate a lot of annual income, said Bob D. Scharin, senior tax analyst at RIA, a provider of tax information and software to tax professionals.

"If a child is 16 and has that kind of investment income, invest in things that don't generate current income, such as growth stocks," he said.

Roth IRAs

For higher-income taxpayers, the Roth IRA has been out of reach, because the old law said only those with income below $100,000 could convert their traditional IRA to a Roth IRA.

That shut out affluent taxpayers with lots of money in regular IRAs from the benefits of a Roth, which are plenty.

With a Roth IRA, taxpayers can't deduct contributions, but the money grows tax-free and withdrawals may be tax-free if certain requirements are met.

Starting in 2010, the new law lifts the income limits to conversions, so that all taxpayers — regardless of income — will be able to convert a traditional IRA to a Roth IRA.

"The elimination of the $100,000 ceiling has higher-income taxpayers and their financial advisers salivating," CCH analysts said in analysis of the new tax law.

But taxpayers must remember that they must pay taxes when they convert to a Roth IRA, Mr. Eads said.

"The question I raised was, will the conversion make sense?" he said. "Upon conversion, income tax will be due. You are banking on the fact, if you convert, that you would be in a higher retirement tax rate at the time you begin to take Roth IRA distributions."

You would have an advantage if your investment return goes up before you make the Roth withdrawals, Mr. Eads said.

"Other factors I would have to consider to make a conversion would be the life expectancy of the taxpayer and inflation," he said. "The problem with this provision is it does not take place until 2010. Congress could change or eliminate the law by then, depending on the elections in 2008. This would be a revenue producer in 2010 but would cost the government money in the long haul due to the tax-free distributions."

Most tax experts believe that a conversion to a Roth IRA would be a good move because future tax rates aren't likely to go down significantly, CCH analysts said.

There's also an added incentive to convert: 2010 is the last year for the current low tax rates before they sunset in 2011.

AMT

Finally, lawmakers continue to administer a Band-Aid solution to the increasingly perilous quirk in the income tax system called the Alternative Minimum Tax.

The AMT is a parallel tax system created by Congress in 1969 when it discovered that many affluent taxpayers were paying little or no tax by cleverly using tax deductions and credits. The intent was to ensure that the wealthy paid at least some tax.

The AMT comes with its own tax brackets and set of rules that's parallel to the regular federal income tax system. It's triggered when a taxpayer claims large deductions such as unreimbursed employee expenses, has lots of dependency exemptions or has high local and state taxes.

Because the AMT isn't inflation-adjusted, it's ensnaring more middle-income and upper-middle-income taxpayers.

Congress tried to fix the problem in 2003 by raising the AMT exemption amount — which reduces the income subject to tax — to $58,000 for married couples filing joint tax returns and $40,250 for single taxpayers.

The exemption amounts were extended through the end of 2005.

The new law again extends the exemption levels for another year through the end of this year but at higher amounts — $62,550 for married taxpayers and $42,500 for single taxpayers.

Expect Congress to return to this issue again, because it only established a temporary patch.

"Congress hasn't found the wherewithal to repeal the AMT or reform it," CCH analysts said. "The Tax Reconciliation Act, like many tax bills before it, merely provides limited AMT relief."