The Jobs and Growth Tax Relief Reconciliation Act of 2003 offered several benefits for both individuals and businesses, following some personal income tax rate reductions that were originally scheduled by the 2001 Tax Act.
Unfortunately, political compromise placed sunset provisions on many parts of those acts. Congress may surprise us by extending some tax breaks that are due to expire.
This article will try to give some highlights of changes for 2006. But because tax law changes every year, it is important for every business owner to work with a financial planner and/or a certified accountant to advise him or her on the most successful tax planning strategy.
This article will cover some of the highlights of the current tax law, but the most beneficial tax planning strategy for anyone will largely depend on his or her individual circumstances.
2006: deductions increase
Luckily, in 2006, we all get a cost of living increase in the amount of money we keep due to the automatic 3 percent increase in the income levels for the five tax brackets. This means that more of your income will be taxed at the lower brackets than in 2005, and you get to keep more of your earned income.
The amount you can deduct for each exemption has increased from $3,200 in 2005 to $3,300 in 2006.
High income earners, however, will end up paying more. You lose all or part of your exemptions if your adjusted gross income is above a certain amount. The amount at which the exemption phase-out begins depends on your filing status. For 2006, the phase-out begins at:
- $112,875 for married persons filing separately,
- $150,500 for single individuals,
- $188,150 for heads of household, and
- $225,750 for married persons filing jointly or qualifying widow(er)s.
The standard deduction for taxpayers who do not itemize deductions on Schedule A of Form 1040 is, in most cases, higher for 2006 than it was for 2005. The amount depends on your filing status, whether you are 65 or older or blind, and whether an exemption can be claimed for you by another taxpayer.
Gift exemption rises
The gift exemption amount has increased from $11,000 to $12,000. This means you can give someone up to $12,000 and not be taxed.
If you are married, each spouse can give $12,000, meaning $24,000 can be given to one child. If the child is married, another $24,000 (from two gifting spouses) can be given to the spouse, so a total of $48,000 can be given from one married couple to another married couple this year.
Many of our readers don't realize that if they stagger gifts over a period of years they can completely avoid paying taxes on the gifts, versus doing what a lot of people do; keeping all the gifts in their will or attempting to give a big gift all at once, only to let the government get a big piece of it.
Energy conservation credits extend
Energy conservation credits have also been extended, including a credit for an alternative fuel vehicle. There are many things you can do to your automobile and your home to make them more energy efficient that will qualify for a credit. Investments such as a thermostat will qualify, for instance.
From 2006 to 2008, a taxpayer may claim a lifetime credit of $500 ($200 for windows) for making qualifying energy saving improvements to his or her residence.
Qualifying expenditures include installation of certain energy-efficient insulation materials, exterior windows and doors, electric heat pumps and central air conditioning. The credit is 10 percent of the cost of qualifying materials.
From 2006 to 2008, a taxpayer may also claim a $2,000 credit for the installation of solar water heating equipment, photovoltaic or fuel cell equipment in his or her residence. The credit is 30 percent of the cost of the equipment. No credit is allowed for equipment used to heat a swimming pool or hot tub.
Alternative fuel credits
Beginning in 2006, the purchase of qualifying vehicles will allow you to claim a tax credit. This replaces the Clean Fuel Deduction, which expired at the end of 2005.
A credit is available for a variety of alternative fuel vehicles. New hybrid vehicles are eligible for a tax credit up to $3,400, depending on the fuel efficiency of the vehicle. This credit is limited, however, to the first 60,000 vehicles sold after Jan. 1, 2006 per auto manufacturer.
Estate tax exemption rises
The estate tax exemption, also known as the "death tax," rises this year from $1.5 million to $2 million.
On the downside, the ceiling on social security taxes increases from $90,000 to $94,200 in 2006. This means you will pay social security on earnings up to $94,200 for yourself and for any of your employees.
Favorable tax rates on dividends that were enacted in 2003 will remain through 2009.
Most taxpayers will be able to pay taxes on dividends at a 15 percent rate. If you would otherwise fall in the 35 percent tax bracket, this is a huge tax cut, due to the 20 percent spread between the two rates.
The best way for you to pay yourself from your business under these new rules should be left to a tax professional.
However, one consequence of reducing capital gains and dividend tax rates is that it will expose more taxpayers to the dreaded Alternative Minimum Tax (AMT). The AMT was designed to prevent the very wealthy from using capital gains rates to avoid taxation at the higher income tax rate.
The AMT is separate from, but parallel to, the regular income tax system. Most income and expense items are treated the same way for both regular income tax and AMT purposes.
Certain itemized deductions such as charitable contributions are allowed for both regular and AMT purposes, but some income and expense items are treated differently.
Beginning in 2006, the AMT exemptions revert to their 2002 levels. The AMT exemption for couples married filing jointly drops from $58,000 in 2005 back to $45,000 in 2006. This will cause more individuals to pay AMT.
Anyone making over $45,000 could potentially be affected by the AMT. There is a chance Congress will extend the exemption, but at this writing, it is uncertain.
Otherwise, certain tax credits which would otherwise lower your tax bill will be removed for individuals paying the AMT in 2006. These credits include the dependent care credit, credit for the elderly and permanently and totally disabled, mortgage interest credit, hope and lifetime learning credits, and a few other credits.
Section 179 deduction rises
Looking at some changes that more specifically affect business, the maximum section 179 deduction you can elect for property you placed in service in 2006 increases from $105,000 to $108,000 for qualified section 179 property.
This limit is reduced by the amount by which the cost of section 179 property placed in service during the tax year exceeds $430,000.
There was a period in 2004 when you could write off investments of up to $100,000. The amount you could expense in one year increased from $25,000 to $100,000; this has been removed.
Retirement plans still offer opportunities to escape taxes.
You can contribute $1,000 annually to an IRA, and that money is not taxed.
There are two big changes to retirement plans this year that deserve to be highlighted. First, the catch-up contributions for individuals age 50 and over doubled from $500 to $1,000 in IRAs and from $4,000 to $5,000 in 401k, 403b and 457 plans.
Roth 401k takes effect
Secondly, the Roth 401k takes effect this year. The popularity of the Roth IRA has finally opened the door for these types of accounts at the 401k level. Many self-employed people would still prefer the current year deductions of the traditional plans, but it is nice to be given the choice.
The big advantage of the Roth 401k is that the withdrawals are not taxed. Another is that there is no required minimum withdrawal after 70 and a half years of age, as there is in other 401k plans.
As life expectancies increase, people will want to keep money in their funds instead of being required to withdraw it.
The Roth 401k, like the Roth IRA, exempts the policyholder from any forced withdrawals of funds.
There are also income limits on Roth IRAs that don't apply to Roth 401ks. For example, a working person making over $100,000 a year might not be able to contribute to his Roth IRA because of his income. He can, however, contribute to his Roth 401k, regardless of his income level.
Plans for smaller businesses
Employers with fewer than 100 employees can establish what's known as a savings incentive match plan for employees (SIMPLE), which are low-cost retirement plans. This can be in the form of a 401k or an IRA. It is not subject to the rules that are normally applied to 401ks. This is intended for a sole proprietor or partnership.
The cost to the business owner for a SIMPLE plan is typically $15 per account. The traditional 401k, which has vesting provisions, has much higher administrative costs.
There are mandatory matching and/or profit sharing contributions for a SIMPLE plan. Employers must match dollar for dollar for the first 3 percent of the employee's contribution.
This is like setting up each employee with an IRA and having to make matching contributions. There is no vesting provision, however. Once the employer makes the contribution, that contribution becomes part of the employee's estate.
According to West Federal Taxation's Individual Income Taxes 2006 edition, all employees who receive at least $5,000 in compensation from the employer during any two preceding years and expects as much during the current year must be eligible to participate in the plan, although participation is voluntary. A self-employed person can also participate.
The contribution must be expressed as a percentage of compensation rather than as a fixed dollar amount.
The elective deferral limit increases under the catch-up provision for employees age 50 and over. The deferral limit for 2006 is $2,500.
Options for sole proprietors
Anyone who is self-employed as a sole proprietor or partnership should have a "solo" 401k as their retirement plan. The plan has to be established before December 31, however, which is too soon for many people to know whether they will have funds available for this plan.
The "solo" 401k makes sense for a small family business. There is a higher contribution limit, plus there is a loan provision. You can borrow money from this plan without a penalty plus additional taxes. You can loan yourself the money back.
Other retirement plans will not allow this.
Health savings accounts
One of my favorite savings and cost reduction plans is the Health Savings Account, better known as an HSA. This is where you couple a high deductible health insurance plan with a special savings account.
The contribution limits on these accounts for 2006 are $2,700 for individuals and $5,450 for families with a $700 individual catch-up provision for those over 55. Not only can these plans significantly reduce your health insurance premiums, but they also give you an additional tax deduction.
The money invested in the plan accumulates interest on a tax-deferred basis. When funds are withdrawn to pay medical expenses, the withdrawal is not taxed.
Unused contributions carry over
In six years of using an HSA, my family has maxed-out our deductible only once, and all other years we have come out way ahead by saving and carrying over amounts in our HSA. This is a great savings vehicle that is woefully underused by the self-employed.
Lower tax on International profits
One economic effect that received very little attention last year was the reduction in the tax on profits brought back from overseas corporate activity.
For one year only, the tax rate was reduced from 35 percent to 5.25 percent, and money flowed back into the U.S. from other countries to corporations headquartered here. This money has been a great stimulus to the U.S. economy, and may be even more so in 2006 as that money is put to work through corporate expansion and other expenditures.
Small business owners generally do not have a lot of overseas operations, but one way to take advantage of this is to identify which corporations are cash rich right now and pursue their business. IRS rules state that this one-time windfall cannot be used for executive compensation, so the CEOs are going to want to spend it somewhere.
About the Author
Tom Stark is president of Stark Financial Strategies in Logan, Ga. He can be reached at 770-554-9660 or email@example.com.