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Tax Changes: What They Mean to You
Federal tax legislation enacted in recent years has affected virtually all Americans, with major changes in income tax rates, taxes on dividends and long-term capital gains, estate taxes, retirement savings rules, and education incentives. Some tax changes have already taken effect while others will phase in throughout the decade. Also, the tax legislation contains "sunset provisions," which means some laws will expire after December 31, 2010, unless Congress renews or changes them.
Keep in mind that federal legislation entails myriad details,
and the following represents only a summary of the principal provisions.
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Reduced Income Taxes
The table below lists current federal income tax rates. In addition, the 10% tax bracket applies to the first $15,100 of income earned by a married couple in 2006. For singles it applies to the first $7,550. After December 31, 2010, previously written tax rules will again take effect.
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Dividends and Capital Gains
Dividend income paid by U.S. and some qualified foreign corporations is now taxed at a top rate of 15%. Previously, dividend income was taxed as ordinary income, with rates running as high as 38.6%. The 15% rate is scheduled to expire after December 31, 2010. If it expires as scheduled, dividends will again be subject to prevailing income tax rates.
Be aware that some types of dividend income may not be included in these rules. For example, dividends received from a REIT (real estate investment trust) may not be subject to the new tax rates. Please check with your tax advisor for the various types of dividend income that are exempt from the new rules.
The legislation also reduced the top tax rate on long-term capital gains (gains on assets held more than one year) from 20% to 15%. The new tax rate applies to gains realized after May 5, 2003, and is scheduled to expire after December 31, 2010.
| NEW RATES ON ORDINARY INCOME |
|
|---|---|
| Previous Rate | Current Rate |
| 38.6% | 35% |
| 35% | 33% |
| 30% | 28% |
| 27% | 25% |
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Relief for Parents and Joint Filers
As a result of the 2003 legislation and subsequent extension in 2004, parents of children under age 17 can claim a child tax credit of $1,000 per child through 2010. The credit begins to phase out for single filers and heads of household with adjusted gross incomes of $75,000 or more, married couples filing jointly with incomes of $110,000 or more, and married individuals filing separately with incomes of $55,000 or more.
For married couples who file jointly, the tax legislation attempts to reduce the impact of the so-called marriage penalty: a glitch in the tax rules that results in higher tax bills for some married couples than they'd face if they were single and filing separately. The 15% tax bracket for married taxpayers filing jointly was expanded so that it applies to twice as much income as for single filers. In addition, the standard deduction for joint filers was increased so that it will be double that allowed for single filers.
These new rules are scheduled to expire after December 31, 2010.
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Temporary Higher Alternative Minimum Tax Exemption
The alternative minimum tax exemption
for married couples filing jointly is now $62,550, increased from $58,000. For single
filers, it increased to $42,500 from $40,250. These exemptions will revert to previously lower levels in 2007 unless Congress acts to extend them.
The alternative minimum tax is a federal tax system created
in 1969 to help ensure that wealthier taxpayers didn't use loopholes to completely
avoid paying income taxes. But because the tax was never indexed for inflation,
it has increasingly applied to less affluent households.
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Retirement Savings Vehicles
A number of tax changes benefit those saving and investing
for retirement, including:
Higher Contribution Limits -- The limit on annual
contributions to traditional and Roth IRAs is $4,000 in
2006, and will rise to $5,000 by 2008. After 2008, the
limit may be adjusted annually for inflation. For certain employer-sponsored
retirement plans -- including both traditional and Roth 401(k) and 403(b) plans, as well as 457 and SIMPLE plans -- the annual
contribution limits will be indexed to inflation. Keep in mind, however,
that employers can impose contribution limits that are lower than the government
maximum.
| CONTRIBUTING THE MAX |
||
|---|---|---|
| Tax Year | 401(k) and 403(b) [traditional and Roth], 457 Plans | SIMPLE Plans |
| 2006 | $15,000 | $10,000 |
| 2007-2010 | Indexed to inflation | Indexed to inflation |
Catch-up Provisions for Those Nearing Retirement -- Individuals aged 50 and older can take advantage of new "catch-up" contributions to IRAs and some qualified employer-sponsored retirement plans. For IRAs, the allowable catch-up contribution is $1,000 per year. Participants in 401(k) and certain other qualified employer-sponsored plans who are at least 50 years old are also permitted to make catch-up contributions of $5,000 in 2006 and adjusted annually for inflation. Participants in SIMPLE plans who are aged 50 and older can make a catch-up contribution of $2,500 in 2006 and will be indexed to inflation thereafter through 2010. But before investors can make catch-up contributions, they must first make the maximum regular contribution to their IRA or employer-sponsored plan.
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Estate Taxes
Tax legislation passed in 2001 increased the federal estate tax exemption, reduced the estate tax rate, and will repeal the entire estate tax for the year 2010.
In addition, the 2001 tax act capped the lifetime gift tax exemption at $1
million. After 2009, the top gift tax rate will be the same as the top individual
income tax rate. Over time, these changes will have a dramatic impact on higher-net-worth
individuals seeking to pass more of their wealth to their heirs. Bear in mind that since 2001, many states have enacted or modified their own estate tax rules in response to these changes.
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Summary
- Tax changes accelerate rate reductions on ordinary income. The top rate is now 35%.
- Rates on dividends paid by domestic and some qualified foreign corporations were reduced to a top rate of 15%.
- The top tax rate on long-term capital gains was lowered from 20% to 15% for sales of assets after May 5, 2003.
- The child tax credit on dependent children younger than 17 was raised to $1,000 effective through 2010.
- The alternative minimum tax exemption was raised for both single filers and married couples filing jointly and is scheduled to revert to previously lower levels in 2007 unless Congress extends it.
- The legislation contained a variety of sunset provisions, and some rules will expire by January 1, 2011, unless Congress extends them.
Checklist
- Increase retirement account contributions to take advantage of higher limits.
- When preparing your tax return, remember to claim the child tax credit if you have dependent children under the age of 17.
- Schedule a meeting with a tax or financial advisor to learn how dividend and capital gains tax rules might affect your investment strategy and tax liability.
