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The Tax Prophet Newsletter   Issue # 35 May, 2006

REDUCE TAXES!
CHECK OUT THE TAX PROPHET'S Action Guides


In This Issue:
Introduction
Capital Gains and Losses
Roth IRA
Kiddie Tax
Offers in Compromise
Housing Exclusion
Conclusion


Tax Increase Prevention
and Reconciliation Act
of 2005


Introduction

It must be an election year. What else could explain the misleading title of the newest tax act signed into law on May 17, 2006.

The winners: Investors, because the 15% tax rate on capital gains and dividends will remain in place through December 31, 2010. Also, starting in 2010, the current $100,000 ceiling for Roth IRA conversions will be eliminated.

The losers: Alternative Minimum Tax (AMT) victims who will receive only temporary and minimal relief. Families with children earning investment income could experience a large tax increase.

Those who need to compromise their tax liability with IRS could discover the offer in compromise process unworkable. Finally, taxpayers working overseas will find their housing-cost exclusion limited to less than $1,000 per month.


Capital Gains and Dividends

Capital gains were lowered from 20% federal to 15% for most investments, and this reduction will remain in effect for two additional years. The 15% federal tax rate for most dividends will also remain in place through December 31, 2010. Sales of self-created musical works (compositions and copyrights) are now eligible for the 15% capital gains rate.
Note: The capital gains rate on collectibles remains at 28% federal.


Roth IRA

Starting in 2010, taxpayers may rollover a traditional IRA into a Roth IRA, regardless of income. Currently, taxpayers earning $100,000 or more are ineligible for the Roth rollover. The rollover is taxable at ordinary income rates, but the resulting tax may be averaged over two years. Income earned and distributions from a Roth IRA are tax-free.

Note: Unlike a traditional IRA, a Roth does not have a required minimum distribution at age 70 .


Kiddie Tax

Under prior law, children under age 14 with unearned (investment) income over $1,700 were taxed at their parent's rates (the so-called "kiddie tax"); children over age 14 were generally taxed as independent taxpayers, often 10-15% for approximately the first $31,400 of income. Because of the advantageous tax brackets for children over age 14, many families created trusts and custodial accounts for their children.

No more. Effective immediately, Congress raised the kiddie tax age to 18, thereby increasing the tax burden for families who shifted investment income to their children.

This tax increase will impact family tax planning for college expenses, perhaps shifting towards the so-called Section 529 college savings plans, in which income used for college is not taxed.


Offer in Compromise

The new law requires a non-refundable payment of at least 20% for a lump-sum offer. For an offer based on installment payments, taxpayers must now pay tax installments while IRS considers the offer.

Most taxpayers borrow funds from reluctant friends or family members (friendly lenders)once the offer has been accepted by IRS. Requiring a 20% non-refundable payment before IRS will consider the offer effectively eliminates funding by friendly lenders, since they now risk losing their money without any assurance that IRS will accept the offer.


Housing Exclusion

Traditionally, employees working overseas could deduct the extra cost of housing. The new law limited the maximum housing allowance to less than $1,000 per month, with any excess housing benefits being taxed at higher tax rates, thereby creating a disincentive for taxpayers to work overseas.


Conclusion

Congress continues to reward investors with the lowest capital gains and dividends rates in decades. Wage earners, especially those in states with high income and property taxes, will continue to fall into the AMT trap in increasing numbers.

Also, taxpayers planning to finance their children's higher education through trusts and custodial accounts, will have to reconsider their approach, now that the kiddie tax has been expanded to children under age 18.




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All contents copyright 2006 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet is a registered trademark of Robert L. Sommers.