Planning Preview for 2006

Planning Preview for 2006
You'll have new ways to save and lower your taxes in the coming year.
by Sue Stevens, CFA, CFP, CPA | 12-22-05 | 06:00 AM | E-mail Article | Print Article | Permissions/Reprints

There are a number of significant tax and financial-planning changes scheduled for 2006. It's also a strong possibility that we'll get new legislation increasing retirement contribution levels even more and addressing that goofy sunset provision from the last tax act. Here's what we know for sure now:
Give More in 2006 Good news for those of you who make annual gifts. The exclusion limit has been raised to $12,000 from $11,000. For those of you with large taxable estates, gifting may offer a simple way to lower the estate taxes owed at death by doling out relatively small annual gifts to as many people as you'd like.

That also means if you want to make a gift to a 529 College Savings Plan in 2006, you'll be able to contribute $60,000 without paying gift tax (up from $55,000) and spread the gift out over the next five years.

Inherit More in 2006
Uncle Sam is giving you a New Year's gift in 2006. You'll be able to leave $2 million to your heirs free of estate tax (up from $1.5 million in 2005). This amount is called the "exemption equivalent." For couples, this means you want to try to each own up to $2 million in your names (or in the names of your living trusts). This technique is known as "equalizing" the estates.

Save More in Retirement Plans in 2006
The contribution limits for retirement savings plans will rise in 2006. For 401(k) and 403(b) plans, salary reduction SEPs, or 457 plans, you can contribute up to $15,000 in 2006. Those in SIMPLE plans can contribute up to $10,000 in 2006. Catch-up contributions also rise to $5,000 for retirement plans other than SIMPLEs and $2,500 for SIMPLEs. Overall contributions to defined-contribution plans cannot exceed $44,000 in 2006 (up from $42,000).

If you save in IRAs, the contribution level doesn't change in 2006: You can still contribute up to $4,000. But the catch-up contribution increases to $1,000 (up from $500). That means if you are age 50 or older, you can contribute up to $5,000 to a traditional or Roth IRA.

Save in New Retirement Plans in 2006
January will bring the birth of a new retirement savings plan: the Roth 401(k). The good news, for those of you shut out of Roth IRAs because you earn too much money, is that there are no income limitations for making contributions. So you'll finally have an alternative to non-deductible traditional IRA contributions.

You'll still be limited to $15,000 ($20,000 if over age 50) in any combination of traditional 401(k) and/or Roth 401(k). You'll get an income-tax savings through traditional 401(k) contributions, but not with Roth 401(k) contributions. Similar to a Roth IRA, the Roth 401(k) doesn't give you a tax break for contributions, but after being in the plan for five years, you'll be able to take earnings out tax-free (presumably you'll be able to take out aftertax contributions at any time with no tax or penalty). Distributions from the traditional 401(k) and from the earnings in a Roth 401(k) before age 59H will be assessed a 10% early withdrawal penalty.

Matches on 401(k) contributions can only go into traditional 401(k)s. So even if you are directing your contributions to the Roth 401(k), your match will end up in the traditional 401(k).

You won't be able to move money between your traditional 401(k) and Roth 401(k). When you retire or leave your employer, you'll be able to roll your Roth 401(k) over to a Roth IRA.

If you already have a significant amount of money in your traditional 401(k), you may want to switch to a Roth 401(k) going forward. By holding money in accounts that are taxed differently, you can create a tax diversification effect (similar to diversifying across varying asset classes). If you are younger, you may want to contribute some to each type of 401(k) plan.

As mentioned before, if we go to a sales tax or flat tax in the future, paying income tax now (as you would with aftertax Roth 401(k) contributions) could turn out to be a bad idea. Another potential downside is that the tax law creating the Roth 401(k) is part of the sunset provision from the last tax law that is set to expire in 2010. It's probable that we'll see legislation before that to make it permanent, but no one knows for sure.

Get More Social Security in 2006
Who says there's no inflation? Social Security recipients are getting a 4.1% increase in their benefits for 2006. This will apply to December 2005 benefits that are paid out in January 2006 and future benefits. The government hasn't been this generous since 1991-it's the biggest increase in 14 years.

But there's a catch. Before you get too excited about an average $47 more per month, you're going to have to pony up for 22% higher Medicare Part B premiums. So that $47 increase will shrink to $36 a month on average. Maybe that will help pay the higher heating bills we're going to owe this winter. Or it could cover the prescription drug coverage that's sometimes referred to as Medicare Part D.

Kids Save Too
The "kiddie tax" standard deduction will increase to $850 in 2006 from $800. That means Junior will have $50 more to spend at the iTunes Store.

Adults will also see their standard deductions rise: $10,300 for married filing jointly, $5,150 for singles. If you're over age 65 or blind, you won't see an increase in your additional deduction (still $1,000 for married individuals and surviving spouses, $1,250 for singles). Personal exemptions increase $100 to $3,300.

Good News for the Rich: A Phase-Out on the Phase-Out
If you make more than $150,500 as a married couple filing jointly, you'll start to lose some of your itemized deductions from Schedule A. If that income tops $225,750, you'll start to lose some of your personal exemptions, too.

In 2006, that phase-out of deductions and exemptions will start to be phased out. (You have to wonder who thinks this stuff up.) For 2006-2007, you'll see one third of your phase-out erased. That will increase to two thirds in 2008-2009. In 2010, all of the phase-out will go away, but chances are we'll have new legislation before we get that far.

Medicare Drug Coverage Takes Effect
If you're over age 65, you're probably deluged with all kinds of mail about the new Medicare prescription drug benefit. The first sign-up period runs from November 15, 2005, to May 15, 2006. Coverage is effective January 1, 2006. The plans are voluntary, so you'll have to enroll. The cost is about $37 per month.

If you miss the first sign-up period, the cost of your insurance goes up 1% for each month you delay. That rule is waived if you have "creditable" current coverage. Your current provider will send you a letter telling you if your current policy is "creditable." If it is, you can later switch to the Medicare drug coverage without any penalty.

Here's what to expect:

    * You pay the first $250 out-of-pocket. It's just a standard deductible.
    * From $250 to $2,250, you pay 25% of the cost of your medicine and the government pays the rest. So, 25% of $2,000 is $500. That's the most you'll pay out-of-pocket for this level of costs.
    * From $2,250 to $5,100, you pay everything. So the maximum out-of-pocket for this level   is $2,850.
    * Beyond $5,100 in drug costs, you pay a 5% copay and government is on the hook for the rest.

So basically, if you fully used this benefit, you'd pay $3,600, plus 5% of costs above $5,100, plus your monthly premiums.