What You Should Know About the New Tax Law

President Bush signed the $70 billion tax package that could provide significant tax relief for upper-income Americans into law Wednesday. The provision that has garnered the most attention is one that protects millions of middle-income Americans from being ensnared by the dreaded alternative minimum tax.

But don't get too excited. It's only a one-year fix. And if you were one of the more than 3 million taxpayers subject to the AMT in 2005, chances are likely you'll get hit again this year.

This latest band-aid, which raises the AMT exemptions for 2006 above last year's levels, will merely prevent new taxpayers from paying the tax originally enacted in 1969 to ensure that the very wealthy paid at least something to Uncle Sam.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

The temporary increase in the AMT exemption is one of several tax breaks included in the tax bill.

Although AMT relief has captured the headlines, two other provisions will significantly affect upper-income taxpayers and require some advance tax planning. One extends the maximum 15% rate on capital gains and dividends, due to expire in 2008, through 2010. The other lifts the income restriction -- currently $100,000 -- for taxpayers to convert traditional IRAs to Roth IRAs, which offer tax-free withdrawals in retirement. Both present substantial tax planning -- and tax saving -- opportunities.

Give it to the kids. Beginning in 2008, taxpayers in the 10% and 15% tax brackets will be able to sell assets, such as stocks or mutual funds, without paying any capital gains taxes. This tax-free capital gains period for those in the two lowest income tax brackets will last through 2010.

Mark Birge, a CPA and principal with Aldrich Kilbride and Tatone, an accounting and a wealth management firm in Portland, Ore., says the tax-free capital gains provision presents enormous tax planning opportunities for parents and grandparents. "For any parent who is looking to save tax dollars on funding a child's education, there is a window of opportunity to transfer assets to their kids and allow them to sell them without any federal tax liability," Birge says.

But, he noted, there's a catch. The new tax package also increases the "kiddie" tax age. Under current law, most investment income earned by children under age 14 is taxed at their parents's higher tax rates. The new law will apply the kiddie tax to investment earnings by kids younger than age 18. So, shooting for tax-free gains by transferring appreciated stock to a child will work only if the child sells the stock after his or her 18th birthday.

Conversions for all. The new tax package also lifts the income restrictions for those who want to convert their traditional IRAs to a Roth IRA. Currently, only those with incomes of $100,000 or less are eligible. (However, required mandatory distributions from an IRA do not count toward the $100,000 income limit.) While you must pay income taxes on the entire amount you convert to a Roth IRA, all future withdrawals in retirement are tax-free as long as you are at least 59frac12; and the money has been in the account at least five years.

Upper-income taxpayers will be able to convert their traditional IRAs to Roth IRAs beginning in 2010 and won't have to pay tax on the conversion until the following year, spreading their bill over two years. "It gives people a lot of time to come up with cash to pay the tax," says Bob D. Scharin, senior tax analyst with RIA, a provider of tax information and software to tax professionals.

Scharin says the legislation has significant estate planning implications because Roth IRAs have no mandatory distribution requirements, and withdrawals by heirs are tax free. (Withdrawals from traditional IRAs are taxed in the heir's top tax bracket.)

Shadow tax. Until recently, most middle-income Americans had never heard of the AMT, which is a parallel tax system with its own set of rules. Originally designed to target the wealthy, it has gradually been shifting from a class tax to a mass tax. That's because taxpayers are required to pay whichever is higher -- their regular tax bill or the AMT.

Two factors are driving more taxpayers into the grasp of the AMT. Although several components of the regular tax -- the size of tax brackets, the standard deduction and the value of exemptions, for example -- are indexed for inflation, there are not such automatic adjustments in AMT-land. And, Congress did not cut AMT rates as it trimmed regular tax rates in recent years.

To ease the problem, the tax package would raise the amount of income exempt from the AMT for 2006.

The exemption, which is subtracted from AMT taxable income before determining your tax liability, will rise to $62,550 for married couples filing jointly, up from last year's $58,000. Without congressional action, this exemption would have declined to $45,000 this year, trapping millions more this year. The exemption for single filers will increase this year to $42,500 from $40,250.

Given that the AMT relief is only temporary and limited, "(i)t's not going to make a difference for most of our clients," says Birge. "They may pay less tax than they would have without this patch, but it's not going to take them out of the AMT."

Still, for some upper-income taxpayers, there is real tax relief in this tax bill that is worth looking into.