Upper-bracket Taxpayers Find Some Relief, Some Surprises in Latest Tax Bill, CCH Says

(RIVERWOODS, ILL., June 1, 2006) – The early months of 2006 have been uncomfortable ones for people who like to know in advance just how much they’ll owe in taxes on this year’s earnings, according to CCH, a Wolters Kluwer business and a leading provider of tax information, software and services (CCHGroup.com). But while Congress has yet to act on several “expired” provisions – including the sales tax deduction and a higher education tuition deduction – the picture has become much clearer for many well-off taxpayers with the recent passage of the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). They can now see if they will be subject to the alternative minimum tax (AMT) this year and can start investigating a new opportunity involving Roth IRAs, but some must also consider what to do about the loss of a family tax-planning strategy.

TIPRA increased the exemption used in calculating liability for the AMT to $62,550 for joint filers and surviving spouses; $42,500 for singles; and $31,275 for married persons filing separate returns for 2006. Without the legislation, the exemption would have fallen back to 2001 levels, subjecting perhaps as many as 21 million taxpayers to the AMT.

But many taxpayers will find only lukewarm “relief” in the higher exemption amounts, warned CCH Principal Federal Tax Analyst Mark Luscombe, JD, CPA.

“The AMT will trim other tax benefits that upper-income taxpayers are entitled to receive this year, and, perversely, scheduled tax reductions will expose some people to the AMT for the first time,” Luscombe said.

Relief from Phaseouts Still Limited by AMT

One new tax benefit affected by the AMT is a reduction in the phaseouts for itemized deductions and personal exemptions. With the phaseouts, upper-income taxpayers begin to lose the full value of many itemized deductions and personal exemptions when their income exceeds certain thresholds.

Once adjusted gross incomes go over the itemized deduction threshold, which is $150,500 for joint filers in 2006, taxpayers must reduce the itemized deductions they otherwise could take by 3 percent of the excess.  The reduction is capped at 80 percent of their itemized deductions. 

Personal exemptions are reduced by 2 percent for every $2,500 in excess of the personal exemption threshold, which is $225,750 for 2006.  There is no cap on the phaseout, so high-income taxpayers can completely lose the value of their personal exemptions.

However, in 2006 the phaseouts themselves begin to be phased out.  Taxpayers will compute their phaseouts as usual for 2006 taxes, but then any reduction will be reduced by one-third.  This should produce a windfall for those affected, but precisely because it reduces regular tax, it can increase the size and likelihood of AMT liability.

Scenarios Show Effects

For example, consider a couple with two children, $300,000 in income and itemized deductions of $50,000, including $22,000 in taxes that are not deductible for AMT purposes. They would have had their personal exemptions capped at $4,352 in 2005 and their itemized deductions limited to $45,378. This produced a regular tax of $63,181, but because they were subject to the AMT, their 2005 tax bill actually came to $64,960. In 2006, they can claim $47,010 in itemized deductions and $7,920 in personal exemptions against their regular taxable income, lowering their regular tax to $60,855. But then the AMT steps in to increase their tax to $63,686.

“They’re still better off in 2006, but not by much,” Luscombe noted. “What’s more, unless Congress acts again, the AMT exemption will fall sharply in 2007, increasing their tax bill significantly. In fact, without the AMT relief in TIPRA they would have owed $68,600 in 2006 – $3,640 more than in 2005 on the same income, despite more generous treatment of their itemized deductions and personal exemptions.”

Some higher-income taxpayers may be subject to the AMT for the first time on their 2006 returns precisely because a reduction in the itemized deduction and personal exemption phaseouts lowers their regular tax below AMT levels. Consider a married couple with three children and $500,000 in adjusted gross income and $75,000 in itemized deductions before phaseouts in both 2005 and 2006. Of the total itemized deductions, $35,000 are taxes that are not deductible in figuring AMT.

In 2005, their personal exemptions were completely phased out, their itemized deductions were reduced to $64,378 and as a result they owed $126,530 in ordinary tax, but no AMT. In 2006, they can take more itemized deductions – $68,010 – and they can claim personal exemptions of $5,500, lowering their regular tax to $122,522. But now they owe AMT, which raises their tax burden back up to $125,300. So their taxes fall as a result of reduced phaseouts, but only by $1,230, not the $4,008 they would have seen absent the AMT. And, in their case, increasing the AMT exemption amount has made no difference. At their income level, the AMT exemption itself is completely phased out, and Congress did nothing in the latest law to ease the AMT phaseout.

“As long as the AMT exists in anything like its present form, we’re likely to continue to see this kind of effect,” Luscombe noted.

New Law Removes Family Tax-Shifting

TIPRA has bad news for families who’ve been using their children to shield some of their investment income from high taxes. Up until now, families could make a gift of income-producing assets to a child age 14 or older and have the income taxed at the child’s rate. (The unearned income of a child under age 14 is taxed as the parents’ income.) In practice, this meant that interest income from investments transferred to a qualifying child would be taxed at 10 or 15 percent, rather than at 33 or 35 percent and capital gains would be taxed at 5 percent rather 15 percent.

Under the new law, the child’s unearned income will be taxed at the parents’ rate until the child reaches age 18, so there’s no advantage to transfers made before that age.

What is a family to do if they have already made such transfers? Luscombe suggests that if the child currently holds bonds or other income-producing assets, they should switch instead to assets aimed at capital appreciation, such as common stocks.

“Under the new law, the capital gains rate will fall to zero for people in the 10- and 15-percent brackets in the years 2008-2010,” Luscombe notes. “Assuming that remains the law, anyone as young as age 14 in 2006 will probably be able to take advantage of the zero rate when they reach age 18. There might be a small amount of tax due when selling the existing income-producing asset, but that would be offset by the savings down the road.”

A New Roth Opportunity

One potential windfall for high-income taxpayers under TIPRA is the possibility of qualifying for a Roth IRA. Currently, the law bars contributions to a Roth IRA for anyone with an adjusted gross income of more than $110,000 if filing singly or more than $160,000 if filing a joint return. Income limits also prevent them from contributing to a deductible IRA. They can contribute to a non-deductible IRA, but the tax advantages are slim: the contributions have to be made with after-tax income, any investment earnings will be taxed as ordinary income when withdrawn and those withdrawals must start at age 70 ½. What’s more, a taxpayer with more than $100,000 in adjusted gross income is barred from converting a conventional IRA to a Roth.

But TIPRA offers the opportunity to convert an ordinary IRA to a Roth IRA beginning in 2010, regardless of income. Someone who started a non-deductible IRA now could build up its balances and convert to a Roth IRA in 2010, owing additional tax only on the earnings that had accumulated up until then, and even that tax could be paid “ratably” over two years. Then, the IRA owner would have all the advantages of a Roth IRA – no tax on withdrawal of any further earnings as long as certain holding periods were satisfied and no requirement to begin taking distributions at age 70 ½.

CCH Senior Pension Law Analyst Nick Kaster, JD, points out that while this may be an attractive new possibility, it is far from a sure bet.

“In fact, you’ll be betting on the future of tax rates, on your need for funds sooner than you anticipate, and above all, betting that the tax laws won’t change yet again. With much of the tax code set to expire in 2010 and important elections between now and then, that’s quite a bit of uncertainty to be accounted for,” Kaster noted.

About CCH, a Wolters Kluwer business

CCH, a Wolters Kluwer business (CCHGroup.com) is a leading provider of tax and accounting law information, software and services. It has served tax, accounting and business professionals and their clients since 1913. Among its market-leading products are The ProSystem fx® Office, CCH® Tax Research NetWork™, Accounting Research Manager® and the U.S. Master Tax Guide®. CCH is based in Riverwoods, Ill. 

Wolters Kluwer is a leading multinational publisher and information services company. The Company’s core markets are health, corporate services, financial services, tax, accounting, legal, regulation, and education. Wolters Kluwer has annual revenues (2005) of €3.4 billion, employs approximately 18,400 people worldwide and maintains operations across Europe, North America and Asia Pacific. Wolters Kluwer is headquartered in Amsterdam, the Netherlands. Its depositary receipts of shares are quoted on the Euronext Amsterdam (WKL) and are included in the AEX and Euronext 100 indices. For more information, see www.wolterskluwer.com.

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CCH Tax Scenarios

Scenario 1: Married couple with two children, $300,000 of income, itemized deductions of $50,000, which includes $22,000 in taxes. Note that even if all of their $50,000 of itemized deductions were deductible for AMT purposes, they would still owe AMT.

Scenario 2: Married couple with three children, $500,000 of income with no capital gain or dividend income, itemized deductions of $75,000, which includes $35,000 in taxes. Note that in order to get AMT out of the equation, the taxes would have to be reduced from $35,000 to around $25,100 and replaced with an equal amount of itemized deductions allowable under AMT.