Some welcome tax breaks

Finally! I'm fulfilling my promise made after the Senate's late-night vote last week to pull together the tax provisions that lawmakers considered before they headed out of town. But I'm revising the structure and timetable (again) a bit.

I've been looking through the pension bill that passed last Thursday night, along with various analyses of it -- yes on a Saturday; don't I live the exciting life?! -- and have discovered there's a lot of tax stuff in there.

Specifically, we're talking 100-plus tax provisions in around 1,000 pages of legislation, discussed in a 376-page committee report. Of course, not all of those apply to individual taxpayers. Thank goodness!

But there are more than enough to fill up several blog entries. So that's what I'm going to do. Instead of the one previously-promised posting, I'm going to spread it out a bit. You'll thank me later!

In keeping, however, with my earlier analogy of the latest legislative doings, I'll break this tax examination into three parts:

• The (mostly) good: Tax provisions that passed. These will actually be two separate blog posts. In this first one, I'll look at those related to retirement plans, as you would expect from a pension bill. My next post will be on new tax provisions related to charitable giving.

• The bad: Tax provisions we're waiting on. This is the long-promised revival of several popular tax breaks that expired on Dec. 31, 2005.

• The ugly: Outrageous tax provisions that were offered (and might show up again) in an effort to woo votes. Also known as legislative bribes to colleagues.

So with my fun-filled Saturday night rapidly winding down, let's get started on good tax breaks, part 1.

IRAs forever: Many of the laws governing tax-favored accounts like IRAs and 401(k)s were set to expire in 2010. That's no longer an issue. As soon as W signs the pension bill into law, an action expected very shortly, the rules will be permanent, or at least as everlasting as you can expect from a legislative system that encourages constant meddling with existing laws. But for the foreseeable future, here's what to expect.

IRA contribution limits will stay at $4,000 through 2007, go to $5,000 in 2008 and then be inflation adjusted thereafter. The $1,000 catch-up provision for 50-or-older workers also was made permanent, but it is not indexed for inflation.

Workplace accounts: As for 401(k)s, you'll be able to keep putting up to $15,000 a year in these employer-sponsored plans. I'd love to know how many people -- and just who they are -- get even remotely close to this ceiling. But I suppose we all need a goal to shoot for.

To encourage more of us to start working toward that maximum 401(k) contribution level, companies now can automatically enroll new employees in the plans unless the workers opt out. Yeah, it is a bit paternalistic and not a perfect solution, but I believe it's generally a good idea.

Too many people never even think about signing up, despite good intentions. At least now, many will start putting money into an account. If they find they really need the money for day-to-day expenses, they can stop contributing.

You'll also be able to get investment advice on your 401(k)s. Advice is good; more information to make better investment choices is always welcome.

Sales pitches, however, are not good. Neither are high fees to get the advice. The new soon-to-be law says that the investment advice arrangements must ensure that any fees, including commissions, are not dependent on the investment option you chose.

We'll see how this works in actual practice. JLP over at AllFinancialMatters has his doubts.

Increased IRA mobility: Bouncing back to IRAs, starting in 2007 you can have your tax refund directly deposited into your retirement account. Of course, that's what you were doing with that money, anyway, right? So now this saves you a step.

Beginning in 2008, you'll be able to roll your company savings plan funds directly into a Roth IRA, as long as you meet all other Roth requirements. Previously, to move your 401(k) to a Roth you had to first put it in a traditional IRA and then convert it to a Roth.

The regular-to-Roth conversion rules remain; you'll owe taxes on the untaxed contributions and earnings you move over. But at least that now will all be figured in one fell swoop.

Credit where credit's due: The Savers Credit also was made permanent. This tax break, created to reward lower-income workers who put money into a retirement account, was set to expire at the end of this year.

Now eligible workers can continue to get the credit (details on how it works here). Plus, starting next year, the income level to determine eligibility and actual credit amounts will be indexed for inflation.

Continued college tax consideration: And finally, the new law continues the federal tax exemption for Section 529 plans. These college savings plans have become very popular, in large part because you can withdraw the funds tax-free to pay school costs. That break had been set to expire at the end of 2010.

With the tax-free option now in full and perpetual force, you shouldn't have to tap your own retirement account to keep Junior enrolled at State U.

That's all for now. Coming up next, how the new tax laws will affect your philanthropic efforts.

Comments

[Judy Bean]

The PPA allows non-spouse beneficiaries to roll over assets inherited from a qualified retirement plan into an IRA. My question is, what is the definition of "qualified retirement plan" in this case?

[ron villella]

In the new tax law re:
transfers from a rollover ira to an immediate fixed annuity, e.g. if one transfes 25000 in 2007 from a
100000 ira into an immediate annuity that pays
out 5000 per year beginning in 2007, what is the amount that can be considered part of a Minimum Required Distribution in the year 2007?
Thank you.
Ron

[Kay]

Bill,
Thanks for reading Don't Mess With Taxes and for your question.

I checked with a couple of accountants and they did not know of this requirement. Perhaps what you were told related to the required minimum distributions themselves, and how you need to be clear about any nondeductible contributions to your traditional IRA when figuring just how much you must withdraw. The withdrawal computation is based on deductible money you put in and the earnings. That's why you need to have the paperwork to back up nondeductible contributions (Form 8606). The documentation will establish your cost basis in your account and ensure that your nondeductible contributions are not taxed when you withdraw them. These contributions that you already paid tax on are instead a return of your investment (i.e., your cost basis) in your IRA.

Once you do determine your precise required minimum distribution, then you can roll that full amount if you wish over to a qualified charity, from a traditional IRA or a Roth IRA. Or, as you did, you can take some of the RMD for your own use and transfer some to charity. Also, you can always take out more than the RMD if you want or need to do so. And if you have a large amount of money in your IRA, you can directly transfer up to $100,000 from it in both 2006 and 2007 to a charitable group even if that amount exceeds your RMD.

Here is a good article on the new provision: http://www.giftlegacy.uci.edu/giftlaw/article.jsp?WebID=GL2006-1021&D=200609. I don't see anything in this article about extra withdrawals being required if you rollover IRA money from an account that includes nondeductible contributions.

I hope I answered your question. If you haven't done so already, I would double check with your IRA manager. The company should have information on this new transfer option.

Best regards,
Kay

[Bill Michel]

I have been told that direct rollovers from IRAs to qualified institutions might require a larger than usual minimum withdrawal if one has made non-deductible contributions to his IRA. I need to know about this because I withdrew my minimum required amount ($6100) of which $1500 was rolled over to a church. $290 of the $6100 is my previously taxed basis.
If what I heard is true, must I make an additional withdrawal? I no longer itemize.
Thanks for your help.

[Kay]

Carol,
Thanks for reading and writing.

As for which is the better tax move for a retired taxpayer, withdrawing from an IRA, donating to charity and taking the deduction or donating directly to the charity, avoiding taxable income but giving up the tax deduction, the answer, as it is for most tax questions, is "It depends."

The general assumption is that it would be better for a retiree to directly roll over the donation because it is believed that most senior filers don't itemize, having already paid off their mortgage so they get no interest deduction there and/or receiving age-related property tax exemptions that help keep that deductible tax payment below the standard deduction amount, which, for 2006 returns, is $6,400 for a single filer 65 or older; $12,300 if married filing jointly and both husband and wife are 65 or older. In these cases, if itemized deductions, including charitable donations, don't exceed the standard amount, then the filers get no tax value from their philanthropy.

Also, lawmakers believed that many older filers would welcome the chance to give to a charity without having to include IRA distributions in their taxable income, particularly if such distributions might push them over the earnings threshold that would cause part of their Social Security payments to be taxes, too. This story has details on that. (In case the link doesn't make it through the e-mail system, here it is: http://www.bankrate.com/brm/itax/tips/20010115a.asp.)

Of course, every tax situation is individual, so the above instances might not work at all for some people. You probably should do your taxes both ways (regular taxable distribution and deduction vs. tax-free rollover) and see which works for you. It's relatively easy to do that if you use tax software.

Despite my "maybe" answer, I hope this has been of some help.

You also can find more on this matter in this post: http://dontmesswithtaxes.typepad.com/dont_mess_with_taxes/2006/11/older_philanthr.html

Best,
Kay

[carol]

Under the PPA, if a retiree itemizes deductions, can it be ascertained which is more beneficial to the taxpapyer: (1)withdrawing from an IRA and then donating to charity (thus taking the deduction) : or (2) or donating directly to the charity (taking no deduction but avoiding tax on the IRA withdrawal.)?

[Kay]

Dorothy,
Thanks for reading. Yes, you can take our RMD and then donate the money to a charity. If you do that, you can deduct (if you meet all the other itemized deduction guidelines) your charitable gift. By doing this, the RMD would count toward your taxable income amount in figuring if you owe the IRS anything.

Or, if you don't itemize and wouldn't get a tax break for giving, under a provision of the new Pension Protection Act, signed into law in September, you can have the IRA money (up to $100,000) rolled directly over to the charity. This IRA-to-charity rollover option is available for the 2006 and 2007 tax years to IRA account holders age 70 1/2 and older. For IRA holders who must take out some money via RMD but who don't itemize, this option allows them to give to the charity of their choice and keep that money from counting as taxable income.

This story discusses the new IRA rollover option: http://www.bankrate.com/brm/itax/news/20060816a4.asp?caret=34#10

Here's a GiftLaw article that specifically references RMD eligibility for this option: http://www.giftlegacy.uci.edu/giftlaw/article.jsp?WebID=GL2006-1021&D=200609

As for what is a qualifying charity, here is the Web version of IRS Publication 78, where you can conduct an online search of IRS-approved charities: http://www.irs.gov/charities/article/0,,id=96136,00.html

Also, check directly with the charity you wish to give to. Legitimate ones will be able to show you the material that indicates they are IRS-approved and probably have the paperwork you need to give and/or roll over the gift directly.

Thanks for reading and good luck this tax season.
Kay

[Dorothy Keith]

Can I take my MDR (from my IRA) for this year and use it to contribute to charities we usually donate to annually and those we list on our income tax form?

Fidelity person said she didn't know what "qualifying charities" were and that I should contact IRS. Couldn't find help there online. Thanks, dpk

[John Henry McDonald]

Great sight!!
JHMcDonald"The Finance Guy"
News8Austin

[Russ]

This is the first time I have seen the topic of the change up, elimination of death taxes being replaced by capital gains taxes with the loss of stepped up basis, covered in a general interest type forum, versus tax specialist. Leave it to the blogosphere to cover what really matters. As an inheritance planner I am certain that this new system of taxation at death (not a repeal, really) will cause countless headaches. We already suffer under the documnentaion for lifetime gifts. taxpayers often have to make an educated guess and hope for the best. Keep up the good work!

[Kay]

Suzie,
Good for you! I used to live in DC so I should have remembered that the cost of living and pay if you're good at your job is high enough in urban areas to make this provision applicable. And don't even worry about bragging; As we say here in Texas, it ain't braggin' if it's true!
Kay

[Suzie]

I am one of those who contribute not just 15 but 20K to my 401K. Been doing the max since 1995. Who am I? An IT professional, work in NYC, live on LI, commute by train. This is not to brag, I simply don't know what else to do with the money I earn, so might as well save on taxes...