Recent legislation has modestly reshaped the tax landscape for 2006. New tax credits, AMT exemption amounts, charitable giving provisions, and "kiddie tax" rules are among the changes that present both an opportunity and a challenge for 2006 tax planning. But keep in mind that the window of opportunity for many tax-saving moves closes on December 31.
Starting with the basics: timing is everything
Year-end tax planning is as much about the 2007 tax year as it is about the 2006 tax year. There's a real opportunity for tax savings when you can predict that you'll be paying taxes at a lower rate in one year than in the other. If that's the case, some simple year-end moves can pay off in a big way.
Unless you think you'll be in a higher bracket next year, look for opportunities to defer income to 2007. For example, you may be able to defer a year-end bonus, or delay the collection of business debts, rents, and payments for services. Similarly, you may be able to accelerate deductions into 2006 by prepaying deductible expenses such as medical expenses, interest, and state and local taxes.
Alternative minimum tax (AMT): what you don't know could hurt you
If you're subject to the AMT, traditional year-end maneuvers, like deferring income and accelerating deductions, can actually hurt you. The AMT--essentially a separate federal income tax system with its own rates and rules--effectively disallows a number of itemized deductions, making it a significant consideration when it comes to year-end moves. For example, if you're subject to the AMT in 2006, prepaying 2007 state and local taxes won't help your 2006 tax situation, but could hurt your 2007 bottom line.
The good news: Legislation in 2006 forestalled a dramatic rise in the number of people affected by the AMT. If you're one of the over 3 million individuals still expected to owe AMT in 2006, though, that won't be much comfort. Taking the time to determine whether or not you need to factor in the AMT before you make any year-end moves can save you from making a costly mistake. If you're not sure whether you're subject to the AMT, talk to a tax professional.
It can pay to be green
New tax credits, intended to promote energy efficiency, are available for certain purchases made in 2006. A tax credit ranging from $250 to $3,400 is available to individuals who purchase or lease a qualified hybrid (gas and electric) vehicle. Separate tax credits are available for energy-efficient vehicles using other technologies as well. There's also a tax credit of up to $2,000 available for installing certain solar energy systems in your home (systems used to heat swimming pools and hot tubs don't count). And tax credits are available for more modest energy-efficient improvements as well (although the maximum credit available for all of these items combined is $500):
- Exterior windows (10% of cost, up to $500) Insulation, exterior doors, and certain metal roofs (10% of cost, up to $500)
- Qualified central air conditioning, heat pumps, and water heaters (up to $300)
- A qualified new furnace or boiler (up to $150)
Don't overlook IRA and retirement plan opportunities
Traditional IRAs (assuming that you qualify to make deductible contributions) and employer-sponsored retirement plans such as 401(k) plans allow you to contribute funds pretax, reducing your 2006 income. Contributions you make to a Roth IRA or Roth 401(k) aren't deductible, so there's no benefit for 2006, but qualified Roth distributions are completely free from federal income tax--making these retirement savings vehicles very appealing.
For 2006, the maximum amount that you can contribute to a 401(k) plan has increased to $15,000, and you can contribute up to $4,000 to an IRA. If you're age 50 or older, you can contribute up to $20,000 to a 401(k) and up to $5,000 to an IRA. The window to make 2006 contributions to your 401(k) closes at the end of the year, while you can generally make 2006 contributions to your IRA until April 16, 2007.
If you qualify, consider whether it makes sense to convert some or all of your traditional IRA assets to a Roth IRA. Funds that you convert, to the extent that the funds represent investment earnings and deductible contributions, are considered taxable income. Nevertheless, the potential future tax benefit could outweigh the current tax bill.
Charitable gifts: some rules have changed
For 2006 and 2007 only, you can make a charitable contribution of up to $100,000 directly from your IRA if you're age 70½ or older. While distributions from traditional IRAs are generally subject to federal income tax, these qualified charitable distributions are excluded (because these distributions are excluded from federal income tax, they aren't included in calculating a deduction for charitable contributions). And, they count as qualifying distributions for purposes of the lifetime required minimum distribution (RMD) rules.
Two other specific changes to note:
- Documentation requirements have tightened up for cash contributions--starting in 2007, you must have a bank record (e.g., canceled check) or a receipt from the charity, regardless of the amount of the cash contribution
- For the donation of clothing and household items made after August 17, 2006, no charitable deduction is allowed unless the donated items are in good used condition or better (an exception applies if you claim more than $500 for an individual item and include a qualified appraisal with your return)
"Kiddie tax" casts wider net in 2006
Under some circumstances, the unearned income (for example, interest or dividend income) of your child can be taxed at your marginal income tax rate. In years past, the kiddie tax applied to children under the age of 14. This year, however, that age increases to 18. (For 2006, the kiddie tax rules kick in when a child's unearned income exceeds $1,700.)
So, think twice about making year-end gifts of assets to a child under the age of 18 if those assets will generate interest or dividends, or if they'll be sold before the child turns 18. It might also pay to replace income-producing assets held by a child with growth-oriented investments that do not generate current income.
As always, if you have any questions, please let me know.