2005 Tax and Financial Planning GuideDocument Transcript
WACHOVIA WEALTH MANAGEMENT
2006 Tax and Financial Planning Guide
Two significant income tax bills became law in 2006, and the year is still not over. On May 17,
2006, President Bush signed into law the Tax Increase Prevention and Reconciliation Act of
2005 (“TIPRA”). TIPRA extended the lower tax rates on long-term capital gains and qualifying
dividends through 2010. Prior to TIPRA, these favorable rates were set to expire in 2008.
TIPRA also increased the Alternative Minimum Tax (“AMT”) exemption amounts that were
scheduled to revert to 2002 levels this year. This provision alone will prevent millions of
taxpayers from paying AMT in 2006. This increase is only effective for 2006. Accordingly, in
future tax years, millions of additional taxpayers could become subject to the AMT if Congress
does not permanently extend the higher exemption amounts.
Additionally, TIPRA repealed the income limitations that apply to converting a traditional IRA
to a Roth IRA. This provision, however, is not effective until 2010. As a result, after this new
law becomes effective, anyone can convert a traditional IRA to a Roth IRA, regardless of income
President Bush also signed the Pension Protection Act of 2006 (the “Pension Act”) on August 17
of this year. While this new law primarily addresses pension plan funding issues, it also contains
significant income tax provisions. In that regard, the Pension Act allows certain taxpayers to
make charitable contributions directly from an IRA. Properly structured, the charitable
contribution will not generate taxable income.
The Pension Act also contains a number of provisions that provide additional flexibility in the
qualified plan and IRA area. These include significantly expanding the rules allowing nontaxable
rollovers for beneficiaries of certain qualified plans, allowing direct rollovers of qualified plan
assets into Roth IRAs, expanding the hardship withdrawal rules for Code Section 401(k) plans,
and allowing direct deposit of tax refunds into IRAs. These are discussed in greater detail in the
relevant sections of this letter along with many important TIPRA and Pension Act provisions.
Congress still has not extended several important income tax benefits that expired in 2005. One
such benefit allows taxpayers the option of utilizing either state and local income tax or state and
local sales tax as an itemized deduction. Additionally, the research credit for businesses has not
been extended. Both of these provisions are contained in what has been termed the “trailer bill.”
Although this pending bill has strong bipartisan support, it has not yet become law.
In 2006, there were a number of efforts to first repeal and then reform the estate tax regime.
These bills passed the House but failed to obtain the necessary votes in the Senate. Accordingly,
there has been no newly enacted estate tax legislation to date in 2006. These bills, along with the
2006 estate, gift and generation-skipping tax exemption amounts, are discussed in the Transfer
Tax section of this guide.
Finally, notwithstanding the enactment of two income tax laws already in 2006, Congress and
the President might not be finished for the year. Congress is currently on recess and will
reconvene in November, after the mid-term elections. Many believe that the “trailer bill”
(discussed above) will become law this year. Additionally, Congress might take another shot at
estate tax reform. The results of the upcoming mid-term elections will have a significant impact
on any future tax legislation.
“Kiddie Tax” Planning – Previously, children under age 14 were taxed at their parent’s highest
marginal tax rate on unearned income (typically dividends and interest) over $1,700. This
“kiddie tax” limits the benefits associated with shifting unearned income to younger children.
TIPRA raises the age when children are no longer taxed at their parent’s highest marginal rate
from age 14 to age 18. This change is effective January 1, 2006. As a result of this new law, a
child will be taxed at the parent’s highest marginal rate on unearned income over the threshold
amount until the child attains age 18.
TIPRA also extended the 15% tax rate regarding qualified dividends and long-term capital gains
through 2010 for calendar year taxpayers. Additionally, for taxpayers in the 10% and 15%
brackets, the tax rate for qualifying dividends and long-term capital gains is currently 5%. That
5% tax rate is reduced to 0% in 2008, and that 0% rate is now extended through 2010. This
provides a planning opportunity to gift appreciated property to lower bracket taxpayers who can
sell the property and pay no capital gains tax in 2008 through 2010. As discussed above, children
under 18 will not qualify for this planning technique.
Dividends that qualify for the 15% tax rate do not qualify as investment income for purposes of
deducting investment interest expense (e.g., margin loan interest). As a result, investment interest
expense incurred during the year might not be deductible. It is advisable to review your
anticipated investment interest expense and ensure that you generate sufficient investment
income to utilize that deduction.
Non-qualified stock options that you exercise during 2006 or restricted stock that vests during
2006 will trigger ordinary income tax. Consider the potential increase in your 2006 tax liability
when projecting your tax liability for the year.
A review of portfolio allocations for both taxable and non-taxable (IRA and qualified plan)
accounts is necessary to achieve an optimal level of tax efficient investing. Stocks that generate
qualified dividends and investments with long-term capital gain potential might be more
appropriately held in taxable accounts because those investments are taxed at lower rates than
IRA and qualified plan distributions. Certain types of fixed income investments, which are taxed
at ordinary income rates, might be more appropriately held in qualified plans or IRA accounts. In
that same regard, tax-exempt bonds might become less attractive now with the lower income tax
rates and reduced rates on qualified dividends. Do not, however, alter your asset allocation solely
based on tax laws. Any investment decisions should be made after consultation with your
investment and tax advisors.
Consider timing capital gains and losses to minimize the net capital gains tax (and maximize
deductible capital losses). A net capital loss can be carried forward to future years to offset
capital gains. There is no time limit for this benefit. In that regard:
1. Taxpayers with short-term or long-term capital losses in 2006, or prior years, should
consider recognizing capital gains to offset the loss on their 2006 tax return.
2. Taxpayers with no realized capital gains from the sale of marketable securities in
2006 can still utilize up to $3,000 of capital losses loss against ordinary income.
Pursuant to the Pension Act, individuals can now exclude from gross income an IRA charitable
contribution that constitutes a “qualified charitable distribution.” A “qualified charitable
distribution” is made by the IRA custodian directly to an organization described in Code Section
170(b)(1)(A), other than certain donor advised funds and supporting organizations. Additionally,
IRA distributions are eligible for this exclusion only if made on or after the date that the IRA
owner attains age 70 ½. This Act provision only applies to an outright gift and not to a charitable
Effectively, to qualify for the exclusion from gross income, the IRA distribution cannot be made
to a private (grant-making) foundation, a donor advised fund, or a Code Section 509(a)(3)
supporting organization. The annual limit regarding this exclusion is $100,000 per taxpayer.
Significantly, although not entirely certain, it appears that a qualified charitable distribution is
applied toward the minimum required distribution for that year. A charitable deduction is not
allowed for any IRA charitable contributions that otherwise would have been taxable. This
Pension Act provision is effective for 2006 and 2007 for calendar year taxpayers.
When making charitable contributions, consider donating appreciated marketable securities held
more than twelve months instead of cash to fulfill your charitable goals. When contributing long-
term appreciated securities, you can deduct the full fair market value of your gift and avoid the
capital gains tax. Charitable contributions, however, are subject to the phase out rules that apply
to itemized deductions.
Pursuant to the Pension Act, no deduction will be allowed for charitable contributions of cash,
check, or other gifts of money unless the donor can provide a bank record or written evidence
from the charity that indicates the amount and date of the contribution and the charity’s name.
Neither TIPRA nor the Pension Act contains a provision that allows non-itemizers to deduct
charitable contributions. This has been discussed by Congress and included in prior proposed
legislation, but has not become law. As a result, non-itemizers still cannot deduct charitable
Last year, taxpayers that itemize had the choice of deducting either state and local income tax or
state and local sales tax. The option to select which state tax (income or sales) to deduct expired
at the end of 2005, and Congress has not enacted legislation to extend this provision. Additional
2006 legislation might still address this matter.
The “trailer bill” currently pending in Congress would extend the ability to deduct either state
and local income tax or state and local sales tax, and this bill has strong bipartisan support. If
enacted in its current form, this deduction would be reinstated effective January 1 of this year. If
this bill does not pass, taxpayers will not have a choice but will be allowed to only deduct state
and local income tax. State income tax and state sales tax, however, is not deductible in
Conservation easements have become a popular tax planning technique. In that regard, the tax
benefits associated with conservation easements have been temporarily enhanced. The Pension
Act increases the deduction limits for contributions of qualified conservation easements from
30% to 50% of a taxpayer’s adjusted gross income. This provision is only effective through
2007. As a result, taxpayers interested in this opportunity should act quickly before this relatively
short time frame expires.
Consider consolidating deductions such as investment, legal or accounting expenses, and
medical expenses to maximize your itemized deductions. Increase your withholding (or make an
estimated federal income tax payment) before year-end to ensure that your estimated income tax
payments are sufficient to eliminate or reduce an underpayment penalty. If you expect to owe
state and local income tax, request your employer to increase your state and local tax
withholding (or make an estimated tax payment) before year-end to accelerate the deduction of
those taxes into 2006.
Traditional IRAs and 401(k) Plans
In 2006, the annual contribution limit for Individual Retirement Accounts (IRAs) remains at
$4,000. This limitation remains at $4,000 until 2008, when it increases to $5,000. Taxpayers age
fifty and older can make additional IRA catch-up contributions of $1,000. In 2006, the annual
contribution limit regarding 401(k) plans increased to $15,000 for individuals under age 50.
Individuals age fifty and older can make additional catch-up contributions of $5,000.
The Pension Act allows non-spouse beneficiaries to rollover certain inherited retirement
accounts into an IRA on a tax-free basis. The beneficiary can then make withdrawals from that
IRA subject to the minimum distribution rules of Code Section 401(a)(9). This tax-free rollover
treatment by a non-spouse beneficiary is only allowed with regard to amounts payable from a
qualified retirement plan, tax sheltered annuity or governmental plan under Code Section 457.
This new law applies to distributions made after December 31, 2006.
The Pension Act also allows individuals to deposit income tax refunds directly into an IRA. The
existing IRA contribution limits continue to apply to these direct deposits. This will be effective
for income tax refunds beginning after December 31, 2006.
Prior to TIPRA, only individuals with less than $100,000 of modified adjusted gross income
were eligible to convert traditional IRAs to Roth IRAs. TIPRA repeals the $100,000 income
limitation for converting IRAs to Roth IRAs. This provision is effective after 2009. As a result,
after 2009, effectively everyone can convert a traditional IRA to a Roth IRA, regardless of
income level. This provision does not extend to Code Section 401(k) plans.
Additionally, solely for conversions in 2010, there is a tax deferral provision available. For
conversions in 2010, individuals can elect to report half of the income triggered by the
conversion in 2011 and the other half of that income in 2012. Alternatively, individuals can elect
to recognize all conversion income in 2010.
Based on the effective date of this provision, high income individuals will have four years to
determine whether to convert their traditional IRAs to Roth IRAs. A critical factor in this
analysis is whether the taxes triggered by the conversion can be funded outside the converted
account. If account proceeds must be utilized to pay these taxes, that distribution not only would
be subject to income tax but also would be subject to the early withdrawal penalty.
Additionally, TIPRA allows married taxpayers that file separate returns to convert traditional
IRAs to Roth IRAs after 2009. Under prior law, married taxpayers filing separate returns were
not eligible to convert a traditional IRA to a Roth IRA.
The Pension Act also allows direct rollovers from a qualified retirement plan, government plan,
or tax sheltered annuity to a Roth IRA. This will constitute a valid Roth conversion if all of the
other Roth conversion requirements are satisfied. Pursuant to prior law, individuals were
required to rollover amounts from qualified plans to an IRA and then convert the IRA to a Roth
IRA. This Act provision is effective for distributions after December 31, 2007.
1. Consider making nondeductible contributions to a traditional IRA beginning this year
through 2009, and then convert the traditional IRA to a Roth IRA in 2010, when the
Roth income limitation repeal goes into effect.
2. If you are over age 70 ½ and have a traditional IRA that is subject to minimum
required distributions, consider using your IRA to fund gifts to charitable
organizations during the remainder of 2006 and for 2007.
TRANSFER TAX PLANNING
The House of Representatives passed a number of bills in 2006 that would have significantly
reformed the transfer tax system. First, the House of Representatives passed legislation that
completely repealed the estate tax. That legislation, however, did not receive the necessary votes
needed to pass in the Senate. Later in 2006, the House of Representatives passed a bill that
significantly reformed the estate tax system. In general, this legislation significantly increased
the current estate, gift and generation-skipping tax exemptions and lowered the applicable tax
rates. Again, this bill did not garner the necessary votes required to pass in the Senate.
Accordingly, despite a great deal of discussion and effort, there has been no newly enacted
transfer tax legislation in 2006.
As a result, the estate tax exemption at death remains at $2,000,000 for 2006, as does the
generation-skipping tax exemption. The lifetime gift tax exclusion remains at $1,000,000. These
amounts are scheduled to remain unchanged for 2007. The annual gift tax exclusion remains at
$12,000 per donee ($24,000 per donee for married couples). The annual exclusion for gifts to
non-U.S. citizen spouses is $120,000 for 2006. The highest federal estate tax rate for 2006 is
46%, which is scheduled to decrease to 45% in 2007.
There were a significant number of family limited partnership cases decided in 2006. Taxpayers
prevailed in some cases and lost in others. In that regard, however, several important themes
continue to permeate these cases.
First, it is extremely important that the taxpayer establish a significant non-tax purpose for
creating and funding the family limited partnership. This means a purpose separate and apart
from any tax benefits associated with family limited partnerships. Additionally, it is critical to
follow all partnership formalities in the creation and administration of the partnership, including
maintaining the necessary supporting documentation. It is also critical that the taxpayer obtain a
well prepared appraisal to support the values of any transferred partnership interests.
In the gift tax arena, a taxpayer achieved a significant victory in a case entitled McCord v.
Commissioner. In McCord, the Fifth Circuit Court of Appeals upheld the validity of a defined
value clause. These clauses define the amount of a transfer (typically a gift or sale to a related
party) by referencing a formula rather than a particular number of corporate shares or partnership
units. Depending on the structure, a defined value clause can help reduce or defer the negative
gift tax consequences associated with an audit increasing the value of the transferred property.
Notwithstanding the ruling in McCord, the Internal Revenue Service might still assert that a
particular defined value clause is not effective. As a result, defined value clauses must be
carefully drafted. Please contact your tax advisor if you would like additional information about
this planning technique.
Consider funding education costs through a Qualified Tuition Program or "Code Section 529
Plan." These plans allow individuals to accelerate up to 5 years of annual exclusion gifts into a
single tax year. The Pension Act permanently extended the benefits of Code Section 529 Plans.
Wealth transfer techniques that value gifts by referencing IRS interest rates (such as a Grantor
Retained Annuity Trust or certain Charitable Lead Trusts) remain viable but are somewhat less
attractive than in the past few years. This is because the IRS interest rates utilized to calculate the
gift tax value have steadily increased. The current IRS interest rates, however, remain at
historically moderate levels and could be attractive for particular transactions. Additionally, the
minimum interest rates established by the Treasury Department for a private annuity or
installment sale, while higher than in previous years, remain at relatively moderate levels,
making these techniques a potentially attractive wealth transfer technique for many individuals.
Qualified personal residence trusts constitute a more effective planning structure in a higher
interest rate environment and should be considered as interest rates continue to increase. In a
qualified personal residence trust, a taxpayer effectively makes a gift of a remainder interest in a
residence, thereby reducing the gift tax value of the transfer.
A new tax law impacts business owners that provide 401(k) plans for their employees.
Specifically, the Pension Act provides more flexible hardship withdrawal rules for 401(k) plans.
This new law allows withdrawals from 401(k) plans based on hardship and unforeseen
emergencies regarding any individual listed as a plan beneficiary. This provision is significantly
more liberal than prior law and expands “hardship” treatment to individuals beyond the plan
participant’s spouse or dependents. While this new law allows 401(k) plans to make expanded
hardship distributions, it does not require that plans offer this option.
The enhanced small business expensing thresholds are extended by TIPRA until December 31,
2009. These expensing thresholds are popularly known as Section 179 expensing. The threshold
amounts are indexed for inflation every year. For 2006, the maximum that a taxpayer can
expense is $108,000 of the cost of qualifying property reduced by the amount that the cost of
such property exceeds $430,000. In 2010, the Section 179 limitations revert to $25,000 and
The research credit for businesses expired on December 31, 2005. Although many believe that
Congress will act to extend this important tax benefit, to date this year, that has not happened.
The “trailer bill” currently pending in Congress would extend this provision. If the “trailer bill”
is passed as currently written, the research credit would have a retroactive effective date of
January 1, 2006.
1. Consider placing new business equipment in service before year-end to take advantage
of Section 179 expensing. In many cases, the Section 179 expensing can be applied to
property with the longest depreciation period, allowing recovery of that property’s cost
in the shortest time period.
2. Increase your level of participation in a business activity if necessary to satisfy the
material participation standard associated with the passive activity loss rules. Also,
consider disposing of a passive activity to release any suspended losses.
3. Finally, business net operating losses can be carried back five years. First, determine if
the loss can be fully absorbed by income from the previous five-year period. If the loss
cannot be fully absorbed during the five-year carry back period, or if the taxpayer
prefers not to amend prior year tax returns, the taxpayer can elect to carry the loss
forward for 20 years.
ALTERNATIVE MINIMUM TAX (“AMT”)
TIPRA increased the AMT exemption for 2006 to $62,550 for married couples and to $42,500
for single taxpayers. The AMT exemption amount increase is only effective for 2006. As a
result, future legislation will be necessary to provide necessary AMT relief for 2007 and beyond.
Prior to TIPRA, only the foreign tax credit, adoptive credit, child credit and saver’s credit could
reduce AMT. TIPRA expanded the credits that can be applied against AMT to also include the
dependent care credit, credit for the elderly and disabled, energy-saving credits, tuition credits,
and certain homeowner credits.
Individuals recognizing large capital gains, exercising incentive stock options, paying high state
income taxes or property taxes, or generating significant miscellaneous itemized deductions are
the most likely candidates for paying AMT. Estimate the impact of any year-end planning
techniques on the AMT for 2006.
Many losses, credits, and deductions allowed in calculating regular taxes are disallowed in the
AMT calculation. The following items cannot be deducted in calculating AMT:
• Property taxes on your residence
• State income taxes
• Miscellaneous itemized deductions
• Personal exemptions
If you expect to pay AMT in 2006, consider the following:
• Calculate state taxes payable for 2006 and pay enough to avoid estimated tax penalties. If
the tax due date falls in 2007, consider making payment in 2007.
• Review investment choices, including your investment in municipal bonds. While
municipal bonds generally generate nontaxable interest, the interest income might be subject
to AMT, depending on the type of municipal bonds.
• Accelerate income into 2006 to utilize the 28% AMT tax bracket (if you do not expect to
be in AMT status in 2007).
• Plan the AMT impact of exercising incentive stock options in 2006 and 2007.
Conversely, if you expect to be subject to AMT in 2007 but not in 2006, consider the following:
• Calculate state income taxes payable for 2006 and pay the entire amount in 2006.
• Pay all state and local ad valorem taxes on tangible and intangible property in 2006.
• Defer income until 2007 to utilize the 28% AMT tax rate.
• Exercise Incentive Stock Options in 2006. The exercise of these stock options creates an
AMT preference but is not taxable for regular income tax purposes.
Certain deductions, such as medical expenses, are calculated more restrictively for the AMT than
for the regular income tax. As a result, determining whether to accelerate or defer payment of
these items for optimal tax benefit depends in part on the individual’s AMT status for the current
and succeeding tax years. This analysis also applies to the payment of employee business
expenses and investment expenses. In any event, it is critical that you closely analyze the AMT
since it can significantly impact your tax liability.
The information provided in this letter is for educational purposes only based on current tax laws
and is not intended as tax advice. Always consult your attorney, accountant, and/or other
financial professional before making decisions about your particular tax situation. Except as
otherwise indicated, the enclosed discussion pertains to the impact of Federal income, estate,
gift, and generation-skipping taxes on individual taxpayers. State rules vary and should be
This communication is not a Covered Opinion as defined by Circular 230 and is limited to the
Federal tax issues addressed herein. Additional issues may exist that affect the Federal tax
treatment of the transaction. The communication was not intended or written to be used, and
cannot be used, or relied upon, by the recipient or any other person, to avoid Federal tax