Tax Review:  A Hot TIP(RA)

The Tax Increase Prevention and Reconciliation Act (TIPRA) was signed into law in May.  This column highlights some of the provisions that are most relevant for Kochis Fitz clients.

Capital Gains and Dividend Rates
The centerpiece of the new tax law is a 2-year extension of the 15% top federal tax rate on capital gains and dividends through 2010 (it had been scheduled to expire after 2008).  This provision is particularly valuable to high net worth individuals, whose portfolios generate a significant amount of taxable income which, under previous (and maybe, once again, future) law, would have been taxed at rates as high as 20% (capital gains) and 35% (dividends).  Given the fiscal gymnastics that were required for just this 2-year extension (more on that below), it’s unclear whether these cuts will be extended beyond 2010; but, for a while at least, investors will continue to reap the benefits of these low rates.

AMT Relief
The number of taxpayers ensnared in the alternative minimum tax has held steady at about 4 million per year recently, but that’s only because Congress has, for the past few years, enacted one-year “patches” that keep millions more from falling under the AMT’s sway.  Congress kicked the can down the road again, opting for another patch covering only 2006.  The new law increases the AMT “exemption” amount from $45,000 to $62,550 for one year.  While this will keep up to 20 million “middle income” taxpayers out of AMT in 2006, many of our clients are likely to continue to be subject to this tax.

Roth IRA Conversions
In order to avoid running afoul of the Senate’s budget rules, Congress needed to find a way to boost revenue in 2010 and beyond to “pay” for the 15% tax rate extension.  Ironically, the result is actually a boon for high net worth families.  If it survives future tax law tinkering, beginning in 2010, TIPRA permanently removes all restrictions on eligibility for converting IRAs into Roth IRAs.  Converting would require the taxpayer to realize the tax liability up-front (for IRAs converted in 2010, taxpayers could spread the liability over 2 years), but then the converted Roth IRA would grow free of tax forever.

Tax-free growth makes Roth IRAs a very powerful long-term wealth accumulation vehicle.  This, however, requires that one has other resources sufficient to pay the conversion tax and, then, is particularly true if individuals can afford to avoid distributions during retirement (unlike regular IRAs, no minimum distributions are required for Roth IRAs).  Our wealthy clients will often be able to pass these accounts intact to their heirs, who could then benefit from tax-free distributions over their lifetimes…potentially adding many decades of tax-free growth.

While the Roth conversion opportunity isn’t available until 2010, clients can begin preparing for that opportunity by making after-tax contributions (now $8,000 per year for a married couple, $10,000 if over 50; these amounts increase by $2,000 after 2007) to traditional IRAs now, with the plan of converting those IRAs to Roth IRAs in 2010.  Most Kochis Fitz clients are not eligible to make pre-tax IRA contributions due to income limitations, but the income limitations do not apply to IRA contributions made with after-tax dollars.  Until now, we have routinely advised clients against making non-deductible IRA contributions, since account growth would eventually be distributed as ordinary income rather than at lower capital gain tax rates if funds were invested outside the IRA.  Now, with the Roth conversion income restrictions to be removed in a few years, though relatively small dollars, in any one year, are at stake, non-deductible IRA contributions finally look attractive, as illustrated in the following table, for only five years of contribution:

While TIPRA waives income limitations for Roth conversions, it leaves income limitations ($160,000 for a married couple) in place for annual contributions to Roth IRAs.  However, beginning in 2010, these income limits are effectively removed, too, as one could make a non-deductible IRA contribution and immediately convert it to a Roth IRA, realizing no taxes in the process.  It’s not clear whether this loophole was intentional or simply a Congressional oversight, so it could eventually go away.

As 2010 approaches, we’ll have much more to say about these opportunities.

Kiddie Tax Changes
Minor children have for years enjoyed a small tax advantage in that the first $800 of their investment income is tax-free, and the next $800 is taxed at the child’s low tax rate.  Any investment income over $1,600 has been taxed at the parents’ tax rate… until the child reaches age 14, when all investment income gets taxed at the child’s low rate.  Hence, in addition to other reasons for doing so, parents have enjoyed a small income tax savings opportunity by giving investable assets to their age 14+ children.

TIPRA extends the period of exposure to the parent’s tax rate for another 4 years, until the child is 18.   

This minor change will not extensively impact many Kochis Fitz clients because in recent years most have foregone the small tax savings opportunity of transferring assets directly to minor children and have, instead, utilized other more attractive vehicles, such as 529 plans.

Is this all for now?...Probably not!
TIPRA is just the latest in a long line of tax legislation in recent years.  Regardless of one’s opinions about the political wisdom and economic expediency of these tax cuts, it is likely that future Congresses will continue to face substantial budget deficits, an exploding AMT problem, continued arguments over estate taxes and, looming in the background, the fiscal challenges posed by Medicare and Social Security.  Given this backdrop, it’s safe to bet that that we won’t need to wait long for more action on the tax front.

Greg Schick

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