New Tax Rules For 2008

New zero percent tax rate

Currently, the maximum federal income tax rate for most long-term capital gains and qualifying dividend income is 15%.  For 2007, individuals in the lowest two tax brackets receive the benefit of an even lower 5% tax rate.  Beginning January 1, 2008, however (and continuing through 2010), the maximum federal income tax rate on long-term capital gains and qualifying dividend income drops all the way to zero for individuals in the 10% and 15% federal income tax brackets.

This presents an obvious planning opportunity: Consider making year-end gifts (up to $12,000 per individual gift-tax free) of appreciated assets to family members who are in the lowest two tax brackets.  These family members would then be able to sell the appreciated assets after January 1, 2008, without any resulting federal income tax.  There's one big catch, though: New kiddie tax rules significantly limit the advantage of gifting appreciated assets to your children.

New kiddie tax rules

Special rules can apply when your child has unearned income.  These kiddie tax rules may tax a portion of your child's unearned income at your (presumably higher) marginal tax rate.  Generally, the kiddie tax rules apply when a child has unearned annual income (e.g., interest, investment earnings, taxable gain resulting from the sale of an asset) exceeding $1,700 (2007 figure).

In 2007, the kiddie tax rules apply to children under the age of 18.  The Small Business and Work Opportunity Tax Act of 2007, however, expanded the reach of these rules beginning in 2008.  Starting January 1, the kiddie tax rules apply to children who are under age 19, and to full-time students under age 24.  (There's an exception for any child who earns more than one-half of his or her own support).

The good news: If you've already transferred investments to a child, or intend to do so, you still have a limited window to operate under the old rules.

Alternative minimum tax (AMT): what you don't know could hurt you

If you're subject to the AMT, traditional year-end maneuvers, like deferring income and accelerating deductions, can 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 moves.  For example, if you're subject to the AMT in 2007, prepaying 2008 state and local taxes won't help your 2007 tax situation, but could hurt your 2008 bottom line.

Legislation signed into law in early 2006 brought the most recent in a long series of temporary "fixes" for AMT, but this temporary fix (in the form of increased AMT exemption amounts), expired at the end of 2006.  If Congress doesn't act, the number of taxpayers subject to AMT is projected to increase from 4.24 million in 2006 to 23.19 million in 2007 (Source: Joint Committee on Taxation, March 5, 2007).  Congress is likely to take some action, but the specifics are uncertain, making it important to stay up to date on any new developments.

Don't overlook IRA and retirement plan opportunities

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 2007 income.  Contributions you make to a Roth IRA or Roth 401(k) aren't deductible, so there's no benefit for 2007, but qualified Roth distributions are completely free from federal income tax--making these retirement savings vehicles very appealing.

For 2007, the maximum amount that you can contribute to a 401(k) plan has increased to $15,500, and you can contribute up to $4,000 to an IRA.  If you're age 50 or older, you can contribute up to $20,500 to a 401(k) and up to $5,000 to an IRA.  The window to make 2007 contributions to your 401(k) closes at the end of the year, while you can generally make 2007 contributions to your IRA until April 15, 2008.

If you qualify, consider whether it makes sense to convert some or all of your traditional IRA assets to a Roth IRA.  Funds that you convert, to the extent that the funds represent investment earnings and deductible contributions, are considered taxable income.  Nevertheless, the potential future tax benefit could outweigh the current tax bill.

Also worth noting

• Legislation signed into law this year increased the IRC Section 179 expense limit for small businesses to $125,000.
• Documentation requirements have tightened up for charitable cash contributions--beginning this year, you must have a bank record (e.g., canceled check) or a receipt from the charity, regardless of the amount of the cash contribution.
• This is the last year that a taxpayer age 70½ or older is able to make charitable contributions of up to $100,000 directly from an IRA to a qualified charity, without including the distribution in income.
• 2007 is also the last year for certain deductions, including the option to deduct state and local general sales tax (instead of state and local income tax) and the above-the-line deduction for qualified higher education expenses.

Talk to a professional

When it comes to year-end planning, there's always a lot to think about.  And, this year there are a few extra wrinkles. A financial professional can help you determine which year-end moves make the most sense for you.