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Newsletter
- Summer 2005
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The
Summer 2005 Tax Client Newsletter brings you up-to-date on a number
of important tax law changes for 2005. As a result of tax legislation
over the past few years, there are a number of significant tax
law changes affecting you this year and right now.
You
may be aware through media attention that many of the important
tax law changes are scheduled to “sunset” (go away)
at various dates – some sooner rather than later. You should
think of the “sunset” issue as a future concern and
take advantage of the opportunities available to you now.
The
focus in Washington these days is on Social Security Reform. Congress,
it appears, has placed tax law legislation on the post-Labor Day
agenda. Only time will tell what, if any, tax law changes will
be enacted in 2005. If you recall, this is exactly what happened
last year and in the Fall of 2004, Congress passed and President
Bush signed into law two significant pieces of tax legislation:
The Working Families Tax Relief Act of 2004 and the American
Jobs Creation Act of 2004.
If
you have any questions concerning any of the information being
reported on in this issue of the Tax Client Newsletter,
please contact my office to schedule an appointment.
2004
Tax Legislation
The
2004 Tax Acts (721 pages and 755 amendments to the Internal Revenue
Code) affects a significant number of taxpayers and in a number
of ways. In this issue of the Tax Client Newsletter we will review
some of the most important changes for 2005.
The
Definition of a “Qualifying” Child:
Child-related
tax benefits frequently depend on the existence of a “qualifying”
child. Among the items impacted by the definition are: is the
taxpayer entitled to a dependency exemption, head-of-household
filing status, the child tax credit, the earned income tax credit,
or the dependent care credit? Prior to the 2004 tax legislation,
each of the above items came with its own definition of a “qualifying”
child. Talk about confusion.
Beginning
in 2005, one set of dependency tests applies to the taxpayer’s
“qualifying” children and another test will be used
for “qualifying” relatives. To be a “qualifying”
child and eligible for the dependency exemption, the child:
- Must
be under the age of 19 at the end of the year or a full-time
student under age 24.
- Must
share a home with the taxpayer for more than half the year.
- Must
not provide more than half of his/her support.
- Must
be the taxpayer’s child, grandchild, brother, sister, niece
or nephew.
Under
a new, uniform definition of a child, a taxpayer’s children
include the taxpayer’s natural children, stepchildren, adopted
children and eligible foster children. This new, uniform definition
will be used for other child-related tax benefits.
Alert:
If a child satisfies the test for more than one taxpayer there
are rules in place that favor parents first. This issue can become
tricky and we are available to work you through this.
Child
Tax Credit Increase is Extended:
The
child tax credit which was scheduled to decrease to $700 in 2005
will stay at $1,000 per child through 2010. Keep in mind that
the available child tax credit is reduced (and in some cases eliminated
altogether) if the taxpayer’s modified adjusted gross income
is greater than certain amounts. Note that the new, uniform definition
of a child (see above) did not increase the age at which the child
tax credit is available. The child tax credit is only available
for children under the age of 17 at the end of the tax year.
Tax
Brackets Reduced
One
of the most significant features of the recent tax law changes
was the lowering of income tax brackets. The 2001 Economic
Growth and Tax Relief Reconciliation Act provided that individual
marginal tax rates gradually decline over several years. The Jobs
and Growth Tax Reconciliation Act of 2003 accelerated the
reductions. The new tax rates/brackets are:
| Now |
Was |
| 35% |
38.6% |
| 33% |
35% |
| 28% |
30% |
| 25% |
27% |
| 15% |
15%
(no change) |
| 10% |
10%
(no change) |
Note:
Rates were retroactive to January 1, 2003.
10%
Tax Bracket Increased and Extended:
Both
single taxpayers and joint filers will benefit from an extension
of the 10% tax bracket. For tax years through 2010, the 10% tax
bracket applies to the first $7,000 of taxable income (single
filers) and the first $14,000 (married joint filers). The 10%
tax bracket amounts are adjusted for inflation (started in 2003).
Under the old law, the amounts would have been adjusted for inflation
only in 2004, 2009 and 2010.
For
2005, the 10% tax bracket applies to the first $7,300 of taxable
income for single taxpayers (also for married taxpayers filing
separate) and $14,600 for married taxpayers filing jointly.
Marriage
Penalty Relief Extended:
The
2003 Act changed the so-called “marriage penalty” rules
of the tax code. The marriage penalty is a feature of the tax
code that, in some cases, leaves two working spouses worse off
taxwise than they would be as singles. The marriage penalty comes
about because some features of the tax laws don’t always
double for married couples.
The
2004 Act extends the 2003 marriage penalty relief by continuing
to increase the standard deduction available to married couples
to twice the standard deduction available to single taxpayers.
The 2004 Act extends this relief through 2010.
The
2003 Act expanded the 15% tax bracket for married couples filing
jointly to double that of single taxpayers. The 2004 Act extends
this relief through 2010.
Lower
Capital Gains Rates
Investors
came out a very big winner under the 2003 Act. The top capital
gains rate was lowered from 20% to 15%. The lowest capital gains
rate decreased to 5% from 10%. Note that the lower rates were
effective for transactions after May 5, 2003. The lower
rates are scheduled to expire after 2008.
Taxpayers
in the lowest two brackets (10% and 15%) will get a one-year bonus
in 2008 when they will pay no federal taxes on capital gains.
The tax is reinstated after 2008.
Dividends
Taxed at 15%
Historically,
dividend income was taxed as ordinary income. Under the 2003 Act,
the top dividend rate was lowered to 15%. Taxpayers in the lowest
two tax brackets pay 5%. This is a very significant change when
you consider the fact that the top rate for dividends was 38.6%.
The new lower rates are effective for qualified dividends received
after December 31, 2002. The reduced rates are the same
rates that apply to capital gains.
With
up to a 20 percentage point difference between the highest income
tax rate (35%) and the highest dividend rate (15%), determining
what a “qualifying” dividend is can make a big difference.
To be a “qualified” dividend, the stock must be held
for more than 60 days during a 120 day period starting 60 days
before the ex-dividend date. If this sounds complicated –
it is. Many companies have experienced difficulty in properly
reporting this information to their shareholders. The lower rates
are scheduled to expire after 2008.
Out
of favor for years, dividends on stock have surged back. The 2003
dividend-tax cut has prompted companies to pay out an increasing
share of their profits rather than stash the cash or reinvest
it. Some companies, notably Microsoft, have started paying dividends
for the first time. In 2004, U.S. companies paid out a record
$181 billion in dividends.
Taxpayers
in the lowest two brackets will get a one-year bonus in 2008 when
they will pay no tax on dividend income. The tax is reinstated
after 2008.
Electric
Vehicle Credit and Clean Fuels Tax Deduction
Taxpayers,
who purchase a “qualified electric vehicle” in 2004
or 2005, are allowed a nonrefundable tax credit for 10% of the
costs. The maximum tax credit is $4,000. Note that for vehicles
placed in service in 2006, the amount of the allowed credit is
reduced by 75% and then eliminated for vehicles placed in service
after 2006.
Taxpayers
who purchase a “qualified clean-fuel vehicle” in 2004
or 2005 are eligible for a deduction of up to $2,000. For clean-fuel
vehicles placed in service in 2006, the deduction will be reduced
by 75% and then eliminated for vehicles placed in service after
2006.
The
IRS is, on an ongoing basis, “certifying” vehicles.
The most recent vehicle “certified” is the 2006 Toyota
Highlander hybrid. Please be sure that the vehicle “qualifies”
before making the purchase.
State
Sales Tax Deduction:
One
of the most exciting developments (maybe not for all taxpayers)
in the 2004 Jobs Act was a provision to allow taxpayers to deduct
state and local sales taxes in place of (not in addition to) state
and local income taxes. This election is available for tax years
2004 and 2005. This new deduction is most popular among taxpayers
from states (there are nine) that do not have a state income tax.
Taxpayers
who elect to deduct state and local sales taxes have two options
for determining the deductible amount. Taxpayers may deduct the
actual amount of taxes paid (keep those receipts) or they
may deduct the appropriate amount from tables provided by the
IRS.
If
you pay state income tax, the chances are you’ll come out
ahead with the state income tax deduction. But there are exceptions.
Big spenders should run the numbers. So should residents of states,
including Illinois and Michigan, where income tax rates are lower
than the state sales tax rate.
Alert:
The Alternative Minimum Tax (AMT) may eliminate any benefit provided
by the new sales tax deduction.
States
With No Income Tax:
Alaska
Florida
Nevada
*New
Hampshire
South
Dakota
*Tennessee
Texas
Washington
Wyoming
*New
Hampshire and Tennessee have a state income tax limited to interest
and dividends.
States
With No Sales Tax:
*Alaska
Delaware
Montana
New
Hampshire
Oregon
*There
are some local jurisdictions in Alaska that impose a local sales
tax.
Charitable
Contributions of Cars and Other Vehicles:
Concerned
that too many taxpayers were taking much larger tax deductions
for donated automobiles than the amount the charities were receiving
when the cars were sold at auction, the American Jobs Creation
Act of 2004 enacted some major changes to the rules effective
January 1, 2005.
Under
the 2004 Act, the general rule is that the amount of the deduction
for the contribution of an automobile, boat or aircraft valued
at more than $500 is limited to the gross sales proceeds
obtain by the charity when the vehicle is sold.
The
2004 Act provides for two circumstances in which the old (you
get to deduct the fair market value) rules would apply: (1) the
charity keeps the vehicle or (2) the charity makes significant
improvements to the vehicle before selling it.
On
June 3, 2005, the IRS issued some guidance (Notice 2005-44) on
how the new law will be applied. The Notice says that the new
gross proceeds limits on fair market value hold that if the fair
market value is less than the amount obtained by the charity,
the donor is still to use the fair market value. The Notice also
says that if a charity donates the vehicle or sells it at a nominal
price in furtherance of its charitable purposes, the taxpayer
can rely on the fair market value.
Here’s
the bottom line. If you are thinking of donating a vehicle - do
not believe everything that is being advertised. Call my office
to make sure that you understand any limits you are facing and
whether there are any alternatives available to you.
The
IRS expects to bring in $2.4 billion in extra tax revenue over
the next ten years as a result of the new limits placed on vehicle
donations.
Educator’s
Deduction:
Educators
can deduct (above-the-line) up to $250 of qualified out-of-pocket
expenses paid in 2005. If both spouses are eligible educators
and a joint tax return is filed, each may deduct up to $250. Eligible
“educators” include teachers of K-12, counselors, principals,
and aides in a school who work at least 900 hours during the school
year.
“Qualified”
expenses include ordinary and necessary expenses paid in connection
with books, supplies, equipment (this includes computer equipment,
software and services), and other materials used in the classroom.
Expenses
for home schooling are not eligible for the deduction.
This
deduction is scheduled to expire after 2005.
Tuition
and Fees Deduction:
An
above-the-line deduction is available to taxpayers for “qualified”
tuition and related expenses paid for the taxpayer, the taxpayer’s
spouse, or the taxpayer’s dependent. The amount that can
be deducted is limited depending on adjusted gross income. While
the maximum deduction for 2005 is $4,000, there are some taxpayers
(not eligible for the $4,000 based on their income) who may qualify
for a $2,000 deduction.
This
very popular deduction is scheduled to expire after 2005.
Alert:
If Congress doesn’t extend this tax deduction beyond 2005,
it might make sense for some taxpayers to consider paying for
the first term of 2006 by December 31, 2005. In some cases this
action would result in a tax deduction for 2005. As always, check
with my office before you make any “advance” payments.
AMT:
Here’s
one topic that we would all love to forget about. The Alternative
Minimum Tax (AMT) is designed to prevent high-income taxpayers
from avoiding significant tax liability. A taxpayer’s AMT
for a tax year is the excess of the tentative minimum tax over
the regular tax. All taxpayers subject to the regular income tax
system are also subject to the AMT system. The number of taxpayers
exposed to the AMT is rapidly increasing. The AMT is projected
to affect about 3.8 million taxpayers in 2005 and more than 20
million by 2006. It appears that the government’s definition
of a “high-income taxpayer” is expanding like a balloon.
Taxpayers
subject to the AMT will be happy to know that the 2004 Act extends
the higher AMT exemptions through 2005. The exemptions are:
$58,000
for married taxpayers filing jointly and for surviving spouses
$40,250
for single taxpayers
$29,000
for married taxpayers filing jointly
Unless
Congress acts to extend the higher AMT exemptions, the amounts
will revert to those that applied in the 2000 tax year ($45,000,
$33,750 and $2,250 respectively).
Health
Savings Accounts
One
of the most significant tax law changes for 2004 was the introduction
of Health Savings Accounts (HSAs). The HSAs were created in the
Medicare Prescription Drug Improvement and Modernization Act
of 2003. Effective January 1, 2004, HSAs allow deductible
contributions to be set aside to cover medical expenses that are
not covered by a high-deductible medical plan in which the taxpayer-employee
participates.
HSAs
allow taxpayers to save and pay part of their medical expenses
with tax-advantaged money. The funds that taxpayers put into the
accounts may grow and be used tax-free for qualified medical expenses.
The accounts can be opened only in tandem with an HSA-qualified
insurance policy that has a high deductible – in 2005, at
least $1,000 for single coverage or $2,000 for family coverage.
The
contributor to the HSA – either the employee of the employer
– gets a tax deduction for the contributions going into the
HSA, and then the employee is allowed to withdraw the funds tax-free
in the same year or in a future year to cover their unreimbursed
medical expenses. Contributions that are not used in any tax year
may be rolled over for future use. Upon reaching the age of 65,
accumulated funds in an HSA can be withdrawn tax-free to cover
medical expenses or they can be withdrawn penalty-free (but not
tax-free) for any purpose.
If
you have any question regarding whether a Health Savings Account
is right for you and or your family – please contact my office
to schedule an appointment.
Conclusion:
The
American Jobs Creation Act of 2004 represents the biggest
single piece of tax legislation since the Taxpayer Relief Act
of 1997. When combined with the Working Families Tax Relief
Act of 2004, taxpayers are left with a significant number
of tax law changes. In the Summer 2005 Tax Client Newsletter we
have review many of the most significant tax law changes affecting
you now.
As
always your individual focus should be on how the tax law changes
affect you and how the tax law changes benefit you.
Thank
you for reviewing the Summer 2005 Tax Client Newsletter and for
the opportunity to serve as your tax professional.
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