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Increased Retirement Plan Contributions Allowed for 2005 and 2006

In 2005, individuals can contribute $14,000 per year ($18,000 per year if age 50 and older) to their retirement plans. If you have not, now is the time to review your 2005 year-to-date retirement plan contributions. In many instances, your employer plan will allow you to make changes for the remainder of 2005 to contribute more if you have not maximized your 2005 contributions to your desired level. Even more exciting savings opportunities exist in 2006 with the increase in the contribution limit to $15,000 per year ($20,000 per year if age 50 and older) and the introduction of Roth 401(k) plans and Roth 403(b) plans.

New Retirement Plan Opportunities Roth 401(k) and 403(b) Plans – New in 2006

This is big, really big. Please pay attention and take action. This applies to most workers who are covered by a retirement plan.

Effective January 1, 2006 employers will be able to add a Roth feature to 401(k) and 403(b) retirement plans for their employees. By now most of you have heard of the Roth IRA and know we are advocates of the Roth IRAs. One of the biggest problems in the past is the limitations of the Roth IRA. Either readers were precluded from making any Roth IRA contributions due to income limitations or they were precluded from making large contributions to the Roth IRA because of the Roth IRA limits of $4,000 per year ($4,500 if 50 or older.)

Those restrictions are dramatically reduced or eliminated for currently employed readers that have access to a 401(k) or 403(b) plan. Now, if your employer adopts the Roth 401(k) or 403(b) plan, you will be eligible to contribute up to $15,000/year ($20,000 if 50 or over) income tax free, regardless of your income. The differences between a Roth 401(k) and a traditional 401(k) are that with the Roth 401(k) you use after-tax dollars to fund your elective contributions and that the Roth 401(k) grows income tax free. For example, if your salary is $100,000 and you contribute $20,000 to your existing 401(k) or 403(b) you must pay taxes on $80,000 of wages. Keep in mind though that when you eventually withdraw those retirement funds you will be taxed on the $20,000 in the retirement plan plus all the accumulated investment earnings. What happens if you contribute the same $20,000 to the Roth 401(k) or Roth 403(b)? Your taxable wages will be $100,000 for 2006 thus increasing your current year tax liability. The advantage, however, is that the Roth 401(k) and 403(b) will grow income-tax free for your life, your spouse's life and the lives of your beneficiaries.

The same analysis that applies to the IRA vs. Roth IRA issue applies to the 401(k) vs. Roth 401(k) issue. Our “running the numbers” indicates that for most readers we prefer the Roth 401(k) to the traditional 401(k). We will elaborate in our next newsletter.

Roth IRA Conversions Available to More Taxpayers for 2005 and Beyond

Starting in 2005, income from an IRA owner’s minimum required distribution is no longer a factor in determining whether you are eligible for a Roth IRA conversion.

If you are over 70½ and were previously unable to make a Roth IRA conversion because your minimum distribution from your IRA pushed you over the $100,000 adjusted gross income limitation, starting in 2005 you will be eligible to make a Roth IRA conversion. This should be a wake up call for individuals 70 1/2 or older that think you can’t make a Roth IRA conversion when there is an excellent chance you would qualify.

New Tax Laws Passed in 2005

Energy Tax Incentives Act of 2005
The Energy Tax Incentives Act of 2005 provides multiple provisions aimed at improving energy efficiency. Most of the benefits are aimed at much larger business entities. There are, however, some provisions in this recently passed legislation that provide incentives to individual taxpayers. These provisions will take place beginning in 2006 and are set to expire at different dates. I want to bring it to your attention because delaying the planned purchase of certain items into 2006 will provide additional tax savings. These incentives come in the form of tax credits. Tax credits reduce federal tax bills on a dollar-for-dollar basis, but, like many other tax credits in place, its apparent benefit may be offset by AMT (Alternative Minimum Tax). Unlike many tax credits in the Internal Revenue Code, these energy tax credits are not phased out for higher-income individuals.

The purchase of Alternative Technology Vehicles that are Treasury Department certified qualify for these new credits. Included in this class of vehicles are hybrid vehicles: one that uses both gas and electricity to propel the vehicle. Also included are fuel cell vehicles, advanced lean burn vehicles and alternative fuel motor vehicle. Electric vehicles that qualify for the electric vehicle credit are excluded from the definition. The hybrid vehicle credit for passenger automobiles or light trucks with a gross vehicle rate of not more than 8500 pounds will range from $400 to $2,400 depending on fuel economy plus a conservation credit of $250 to $1,000 based on lifetime fuel savings. This credit replaces the clean-fuel “hybrid” vehicle deduction.

A non-refundable credit is available for the purchase of energy-efficient improvements to existing homes located in the United States. Qualifying improvements include insulation, windows, doors, furnaces, and hot water heaters. A qualifying purchase will be mainly based on manufacturer certifications in the materials that come with their products. The credit is based on a percentage of the cost of the qualifying item. For example, you will take a tax credit for up to 10% of the cost of qualifying windows up to a maximum credit of $200. There is a maximum lifetime credit of $500 for all of the qualifying purchases mentioned above.

Hurricane Katrina Emergency Tax Relief Provides Opportunities for Charitable Individuals
Congress increased the deduction limit for cash contributions made between August 28, 2005 and December 31, 2005 to all public charities (including charities unrelated to Katrina cleanup efforts) from 50% of adjusted gross income to 100% of adjusted gross income. Please consult with a tax professional if you are contemplating a large year-end charitable gift.

Topics of Special Interest

Expiring Provisions in 2005 – Take Advantage in the Event that the Provisions are Not Extended
Although the likelihood of any new tax bill actually passing by the end of this year is limited, there are proposed bills in both the Senate and the House that include extending these expiring provisions. The following expiring provisions are the ones that affect individual taxpayers. You should make the most of this opportunity to capitalize on these deductions or credits before year-end.

The Alternative Minimum Tax Trap
In 1969, Congress enacted the Alternative Minimum Tax (AMT) to grab the 155 super wealthy taxpayers who were going to escape income tax altogether using tax shelters and the like. Roll the clock forward and in 2004 roughly 3,000,000 taxpayers were hit with AMT. Temporary provisions intended to mitigate the effects of AMT are set to expire at the end of 2005. Without some AMT reform an estimated 21,000,000 would pay AMT in 2006. Legislative lawmakers are in a bit of a quandary, as the AMT has become a money machine. The cries for AMT repeal are louder than ever on Capitol Hill. According to treasury data, repeal of the AMT would reduce federal tax revenues approximately $348 billion dollars over the fiscal year periods 2006 to 2010. If the 2001/2003 tax cuts were extended, then repealing AMT would reduce federal revenues by over a trillion dollars between 2006 and 2015. In fact, the treasury department has estimated by 2013 it would be less expensive to repeal the regular income tax than it would be to repeal the AMT.

Because of the complexities of the AMT tax calculation traditional tax planning to minimize taxes can backfire when you are subject to AMT. Planning for the AMT is complex. Running the numbers prior to year-end can be advantageous. For most of those taxpayers who were subject to AMT in 2004, be prepared to be subject again in 2005 and consider “running the numbers” and deciding on appropriate action.

The Working Families Taxpayer Relief Act
A centerpiece of the Working Families Taxpayer Relief Act is the definition of a qualifying child. The “qualifying child” definition has been expanded to include individuals who are not the biological child of the taxpayer (for example, a brother or sister can now be a taxpayer’s qualifying child). This expanded definition will allow a child tax credit for a qualifying child (still must be under age 17) who may not have been eligible in 2004 under the old dependency rules. There is a new law change that will now disqualify certain taxpayers from being able to use head-of-household filing status in 2005. The qualifying individual must now be a qualifying child or an individual for whom the taxpayer may claim a dependency exemption. The old law did not require that the individual be an eligible dependent.

Extended Section 179 Expense Rules offer Flexibility
The American Jobs Creation Act of 2004 extends to years 2006 and 2007 the higher amount of eligible property that may be expensed under Section 179. The maximum dollar amount eligible for section 179 expense in 2005 is $105,000.

These rules allow taxpayers to reduce income taxes by fully expensing purchases of qualifying assets used in business (such as computers and other equipment) in the year of purchase.

Sell that SUV for a Tax Write-off
In the early fall, gasoline prices rose to levels in excess of $3.00 a gallon. The sports utility vehicle (SUV’s) industry has felt the backlash of these price increases as consumers began looking for more economical transportation. There were some car dealers that wouldn’t even accept them as a trade-in for a new vehicle. In most instances, if you are using your SUV for business purposes your remaining income tax basis is greater than the fair market value of the vehicle. If you are someone in this situation, you should consider selling the vehicle, take the tax loss write-off and use the proceeds on the new purchase. If you instead choose to trade-in the vehicle for a new business use vehicle, any loss cannot be recognized immediately due to the tax rules for like kind exchanges.

Other Ideas to Reduce Taxable Income and Reduce Taxes

Focus on Reducing Your Adjusted Gross Income
Many taxpayers have some ability to reduce or increase their adjusted gross income. Projecting your current year adjusted gross income and taking steps before year-end to lower this amount can result in reducing your overall tax liability by thousands of dollars. Reducing your adjusted gross income helps preserve certain tax breaks you may otherwise lose or avoids additional taxable income you would not otherwise have such as:

Elective Deferrals for Retirement Savings
Retirement savings incentives and pension plan reform reflect increased contribution limits for 2005 and 2006. The 2005 limits for elective deferrals to 401(k)s, 403(b)s, and section 457 retirement plans increases to $14,000 ($18,000 for individuals age 50 and over). The 2006 limits for these elective deferrals increase to $15,000 ($20,000 for individuals age 50 and over). Please see the description of the Roth 401(k) and Roth 403(b) above.

Keep in mind that contributions to elective deferral retirement plans and self-employed retirement plans will reduce your adjusted gross income. See the partial list of tax deductions and tax credits above that are directly affected by adjusted gross income.

One-Person 401(k) Plan
Small business owners have been waiting for a plan that would allow them to set aside more money, with tax-favored treatment for retirement. The biggest potential benefit of the one-person 401(k) goes to one-person businesses earning between $50,000 and $160,000. An unincorporated business owner earning $50,000 could shelter roughly $23,300 in 2005 or 46% of earnings! (For owners over age 50, these amounts are roughly $29,300 or over half of earnings.) This plan must be established and funded with all elective deferrals no later than December 31, 2005 in order to make a contribution based on 2005 earnings.

Individuals already participating in 401(k) or 403(b) elective deferral plans at work, while earning additional income from a side business, are not the best suited to take advantage of this type of plan because of limitations on combined elective deferral contributions.

Tax Loss Harvesting
Many readers will have capital loss carry-forwards to use in 2005 and possibly beyond. Using losses to reduce taxable gains by offsetting the losses against the gains is referred to as “tax-loss harvesting or tax-loss selling.” Now is the time to review your investment portfolio and make some decisions that will generate tax savings.

It is required for income tax purposes to match your short-term gains with short-term losses and your long-term gains with long-term losses. You should always make sure that you never end up with short-term taxable gains by failing to sell securities that will create a loss to offset these short-term gains prior to year-end. Any remaining short-term gains are taxed at ordinary income rates that are as high as 35% in 2005. It may not always be the best decision to recognize losses in the current year. For example, you have a net long-term gain that is going to be taxed at 15%. You also have unrecognized long-term losses in your portfolio. You are advised to sell the stock and offset the long-term gain with the loss and pay no income taxes. What if you knew prior to the end of the year that in January of the following year you were about to recognize a nice short-term profit on a stock? By harvesting those losses in the same year as taking the short-term gain you may save income taxes of up to 20%. If you do have excess losses in any tax year you can deduct up to $3,000 of losses against ordinary income. That adds up to an $840 tax savings for an individual who is in a 28% tax bracket. Be careful to avoid a wash sale, i.e., buying the same security within 30 days of the time you sell the shares—the tax rules will disallow the loss.

Many investors fail to maximize the benefits by specific lot selling. Keeping track of your stock purchases at lot levels (instead of the First-In, First-Out default method) allows for greater control when instructing your broker to sell shares.

Harvesting your investment losses can reduce your capital gain income to zero. It’s a great way to increase the after-tax rate-of-return on your portfolio without the risks of active trading. In combination with a good asset allocation and reallocation strategy, you can add value to your investment portfolio without increasing your investment risk.

Transfer Appreciated Stock to Children 14 Years Old or Older
Consider transferring stock to your child. For example, assume you are in a 25% tax bracket and are planning to sell some appreciated long-term stock to pay for your child’s education. Your child is in a 10% tax bracket for ordinary income. Consider making a gift and transferring the stock to your child who subsequently sells the stock. You have effectively shifted long-term capital gains from a 15% taxation rate to your child’s long-term capital gains tax rate of 5%. You should keep in mind that there are no strings attached to these types of gifts. When you consider this type of transaction the money now becomes your child’s money.

Oldies, But Goodies
Make or Increase Retirement Plan Contributions: Business owners can reduce AGI by increasing contributions to pre-existing retirement plans or establishing a new plan such as 401(k) plans, SIMPLE pension plans, SEPs, Keogh plans, or regular (deductible) IRAs. Most self-employed retirement plans allow for deductions in tax year 2005 even for contributions which are made after year-end but before the extended due date for filing the return. In other words, payment of 2005 deductible retirement plan contributions can be postponed until October 15, 2006 with an automatic extension. (In previous years, there were two extensions – good through August 15 and October 15. Now there is just one, and it is good through October 15.)

Maximize Loss Situations: If you are experiencing an unusual tax year where you may be in a much lower tax bracket than usual or even in jeopardy if wasting itemized deductions and personal exemptions, careful tax planning can be more crucial than ever. Make sure you project your taxable income before the end of the year and examine all your alternatives. There may be steps to take to avoid wasting deductions such that taxes can be lowered in future years.

Enroll in a Cafeteria or Flexible Spending Plan: If the 2006 enrollment period is still open, please consider enrolling in your employer’s Cafeteria or Flexible Spending Plan. This strategy allows you to pay for medical, child-care and other qualified expenses with pre-tax dollars. Medical expenses are rarely fully deductible on Schedule A due to the 7.5% of AGI limitation. Medical costs paid for through your company’s cafeteria plan will allow you to fully deduct your medical expenses from your taxable W-2 federal and social security wages.

Make a good estimate of your projected qualified expenses for the year. If you set aside more pre-tax dollars than you will be able to claim, the unused portion is forfeited subject to Notice 2005-42 described further below. Don’t let the forfeiture risk deter you from participating, just be a little more conservative in your estimate. If you are currently enrolled in a program, review your outstanding balance, and if necessary, schedule a dentist, doctor, optometrist, chiropractor, etc. appointment before December 31st.

IRS issued Notice 2005-42, extending the deadline by which participants in an Internal Revenue Code Section 125 cafeteria plan must incur medical expenses to receive reimbursement under the plan. Prior to Notice 2005-42, cafeteria plan contributions only could be used to pay for expenses incurred in the same plan year in which such contributions were made. Contributions that could not be applied to expenses incurred in the same plan year were forfeited under the IRS “use it or lose it” rule. Under Notice 2005-42, an employer may amend its cafeteria plan to permit reimbursement for expenses incurred up to 2½ months after the end of the plan year. For example, a participant in a calendar year plan may pay for medical expenses incurred on March 15, 2006 with health care flexible spending account contributions made in 2005.

Take Advantage of Pre-Tax Parking Breaks: If your employer offers pre-tax dollars to be used for parking, mass transit or van pools, take advantage of the tax savings. Many individuals are not afforded the luxury of being able to deduct personal parking costs. Using this fringe as a component of employee compensation can create tax savings for both parties.

Preserve Student Loan Interest Deduction: Consider obtaining student college loans in the student’s name instead of the parent’s name where the parent’s income is too large. Deferring the payment of student loan interest until after graduation may preserve the deduction for payment of interest on student loans. Most college grads start out with salaries that would allow a full deduction for the interest paid. Conversely, if the loan is in the parent’s name there is a higher possibility that the interest would be non-deductible. The parents can always make monetary gifts to help repay the loan interest.

Make a Roth IRA Contribution: If you qualify, making an annual $4,000 Roth IRA contribution for 2005 (up to $4,500 if over the age of 50 by the end of 2005) both for you and your spouse will help you accumulate tax-free wealth. The contribution limits remain at $4,000 for 2006 (up to $5,000 if over the age of 50 by the end of 2006). You have until April 15, 2006 to fund a 2005 Roth IRA.

Make your Non-Cash Charitable Deductions before December 31: The IRS allows you to deduct either the cost or the fair market value, whichever is lower, for your non-cash contributions. Please remember to ask for a receipt. You must prepare an additional tax form if your non-cash contributions exceed $500.

Donate Appreciated Stock Instead of Cash to your Favorite Charity: If you hold appreciated publicly traded stock for more than one year, you can donate the stock and get a charitable deduction for the full market value of the stock and avoid paying any capital gains tax. You must give the stock directly to the charity. The opposite is true for stocks that have gone down in value. Never donate stocks that have declined in value, but rather sell the stock at a loss and donate the cash to charity.

Self-Employed Individuals Should Consider Employing their Child(ren): Employing your child (age permitting) offers great tax-saving opportunities. Assuming your child has no unearned income, the parent could pay the child wages up to $5,150 in 2006, and the child would not have to pay any federal income taxes. The next $7,550 would be subject to a 10% tax rate. If the parents’ marginal income tax bracket were 28%, the $12,700 wage deduction would generate $2,801 in federal income tax savings. Furthermore, when you employ a child under 18-years-old, neither the employer nor the employee is subject to social security tax on the child’s wages. The wages your child earns will qualify as earned income for the purpose of establishing a Roth IRA. A Roth IRA will provide your child with an exceptional opportunity to accumulate money with tax-free growth.

Self-Employed Individuals with No Employees Should Consider Employing Their Spouse: A self-employed individual may be able to deduct all of his or her health insurance premiums and medical expenses by setting up a medical reimbursement plan with his/her spouse as the only employee of his/her business. Self-employment taxes could then be saved on all the deductions under the medical reimbursement plan. Your spouse must become a bona fide employee of your business. Theoretically, that means your spouse will be working under your control. Good luck.

I wish you and your family a joyful holiday season and a healthy, prosperous new year.

Warmest personal regards,

James Lange
CPA/JD

P.S. If you are over 70½ and were previously unable to make a Roth IRA conversion because your minimum distribution from your IRA pushed you over the $100,000 adjusted grow income limitation, please contact a qualified adviser with expertise in Roth IRA conversions. If you live in Pennsylvania or Ohio and do not have an adviser with Roth expertise, please call our office to see if you qualify to work with me.

James Lange is a tax attorney and CPA with a thriving retirement and estate planning practice in Pittsburgh, Pennsylvania.  He focuses on the unique needs of individuals with appreciable assets in their IRAs and 401(k) plans.  His plans include tax-savvy advice, will and trust preparation, and intricate beneficiary designations for IRAs and other retirement plans.  Jim's advice and recommendations have received national attention from syndicated columnist Jane Bryant Quinn, and his articles are frequently published in Financial Planning, Kiplinger's Retirement Report and The Tax Adviser.