Year-End Tax Planning—New Challenges and Opportunities

Year-End Tax Planning—New Challenges and Opportunities

Several pieces of legislation have modestly reshaped the 2006 tax landscape. New tax credits, AMT exemption amounts, and “kiddie tax” rules are among the provisions that present both a challenge and an opportunity for 2006 tax planning. Don’t be caught off guard–set aside some time now to evaluate your tax situation while you can still affect your bottom line for the 2006 tax year.

Alternative minimum tax (AMT) can throw a wrench in year-end planning

Deferring income to next year–for example, by delaying a year-end bonus–might pay off in a big way, especially if you’ll be in a lower tax bracket in 2007. Similarly, you might want to accelerate deductions into 2006 by prepaying deductible expenses such as medical expenses, qualified interest, and state and local taxes. If you’re subject to the AMT, however, these traditional year-end maneuvers may 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 tax decisions. 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: Recent legislation forestalled a dramatic rise in the number of people impacted by the AMT. If you’re one of the over three 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.

Contribution limits for tax-deferred savings vehicles have increased

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 impact on your 2006 income, but qualified Roth distributions are completely free from federal income tax.)

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) plan 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 15, 2007.

It can pay to be green

New tax credits intended to promote energy efficiency are available for 2006. A credit ranging from $250 to $3,400 is available to individuals who purchase or lease a qualified hybrid (gas and electric) vehicle. There are separate tax credits for energy-efficient vehicles using other technologies as well. There’s also a tax credit available (up to $2,000) for installing certain solar energy systems in your home.

Tax credits are available for more modest energy-efficient improvements as well, including exterior windows (10% of cost, up to $200); 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); and a qualified new furnace or boiler (up to $150). The maximum credit available for these items is limited to $500 for all improvements combined.

“Kiddie tax” casts wider net for 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 gifting assets to children under age 18 if those assets will generate interest or dividends, or if they’ll be sold before the child turns 18. You may also want to consider replacing income-producing assets held by a child with growth-oriented investments that do not generate current income.

Talk to a professional

When it comes to year-end tax planning, there’s a lot to think about. And because there are a few new wrinkles this year, it might make sense to discuss your situation with a financial or tax professional.