Article: Tax Law Changes Kick in for 2008

March 2008

Tax Law Changes Kick in for 2008

The new year brings new tax opportunities and pitfalls

With a number of changes coming our way for the 2008 tax year, taxpayers should be aware of some of the more important opportunities and pitfalls.

IRA Limits. A number of years ago Congress set in place a series of gradual increases in the IRA contribution limits. The final increase occurs in 2008. The annual IRA funding limit, whether for a traditional deductible IRA or a Roth IRA, is now $5,000 per year. For individuals age 50 or over by the end of 2008, the limit is $6,000. (For 2007, both of those amounts were $1,000 less.)

Caution: A full Roth IRA contribution can be made only if the taxpayer’s modified adjusted gross income is under $95,000 for single filers and $150,000 for joint filers. With respect to traditional deductible IRAs, there are income-sensitive limits only if the individual (or spouse) is a participant in another retirement plan.

Mileage Rates. The business mileage rate for 2008 has increased to 50.5¢ per mile, up from 48.5¢ in 2007. The allowance for mileage for medical or moving expenses has decreased to 19¢ per mile (formerly 20¢), whereas the rate for charitable driving remains at 14¢ per mile.

0% Capital Gain and Dividend Rates. There is something about a tax rate of zero percent that really grabs one’s attention. For the first time ever, lower-income filers will be able to report capital gains and dividends at no federal tax cost.

While this might seem to be a tax rate that should be avidly pursued, significant restrictions apply:

The 0% rate is not dramatically different than in previous years, during which dividends and capital gains have been taxed at 5%.
To qualify, the capital gain or dividend must fall into the lower tax brackets. Roughly, that means less than $32,000 of taxable income for a single filer and $65,000 for a joint filer.
Finally, any capital gain or dividend is considered the top portion of an individual’s income. The ordinary income is considered to fill up the lower brackets first, followed by the capital gain or dividend income as the top tier.

In most cases, lower-bracket returns are those of either retirees or children/young adults. But both groups have problems in receiving the full benefit of this new 0% rate.

For the elderly, the big issue is the complicated formula that increases the taxability of Social Security benefits as income increases.

Example. Fred and Ethel are retirees collecting Social Security benefits and have read about the new 0% capital gain rate. They check their tax return and learn that they can absorb about $10,000 of capital gain at 0%. Accordingly, they sell a few stocks and recognize $10,000 of capital gains in 2008. While the $10,000 capital gain has a 0% cost, the extra $10,000 of income causes about $8,000 of additional Social Security benefits to become taxable as ordinary income. This cost Fred and Ethel about $2,000 of additional federal income tax!

For those under age 24, who generally will be in the lower tax brackets to which the 0% rate applies, the new “kiddie tax” may rear its ugly head. Starting in 2008, in a corresponding law change (discussed in later paragraphs), many under age 24 will find their parents’ top tax rate applied to their income rather than their own lower rates. Accordingly, the 0% normally applicable to the capital gains and dividend income of a child or young adult will be taxed at mom and dad’s 15% rate.

In summary, while the 0% rate is intriguing, its limits are more severe than advertised. Please check with us if you have family members who may benefit from the 0% capital gain and dividend rate, and we will assist in determining applicability. In some cases, it may be possible to make gifts of appreciated stocks or other securities to these family members, allowing them to subsequently recognize the gain at a 0% rate.

Expanded Kiddie Tax Rules. In an earlier issue of the Bottom Line, we explained that Congress has expanded the “kiddie tax” beginning in 2008. For the last several years, the kiddie tax, which taxes a child at the parents’ top tax rate, has applied only to taxpayers under age 18. In its simplest form, the kiddie tax imposes the parent tax rate on the investment income of the child that is in excess of $1,700.

Beginning with the 2008 tax year, the kiddie tax is expanded in a complicated manner to potentially reach children through age 23. The kiddie tax applies to those who have their 18th birthday during the year and to those who are in full-time student status (defined as in full-time enrollment at least five months of the year) and who have attained their 19th through 23rd birthday during the particular tax year. Further, for the kiddie tax to apply to this age 18-23 group, the wages and self-employment income of the individual may not exceed half of the amounts expended for the individual’s support for the year.

Example. Bart is a full-time college student, age 20, whose items of support for 2008 total $30,000. This support includes Bart’s room, board, tuition, health care and recreational expenditures for the year, less any scholarships that reduce the outlay for his tuition. His W-2s from summer employment and part-time work at school during the year total $7,000 for 2008. As a result, Bart is subject to the kiddie tax, because his wage income of $7,000 does not exceed 50% of his $30,000 of support for 2008. Accordingly, if Bart has interest, dividends, capital gains and other unearned income in excess of $1,700, that excess will be taxed at his parents’ top tax rate.

Strategies. For parents of 18- to 23-year-olds who will face the expanded kiddie tax in 2008 and after, there are some actions that can help. New investments that are intended as savings for college might be directed toward state-sponsored 529 plans. These investments can be liquidated during college years without any taxation if the funds are expended for higher education, thus avoiding the reach of the new kiddie tax.

For those who are liquidating investments already in the student’s name, the kiddie tax may now be inevitable. But recognize that a child will likely qualify for a Hope or Lifetime Learning tax credit based on the higher education tuition expenditures. This tax credit can be as large as $2,000 and may offset some or all of the additional kiddie tax imposed in the child’s return. In some cases, there is a special election that we can make to decline the student’s dependency exemption in the parent return, in order to qualify the child’s tax return for one of these college credits.

Finally, as a practical matter, recognize that where the kiddie tax applies, parent taxable income will now be disclosed within the child’s return! In this situation, most parents will want to control access to that child’s tax return to assure confidentiality with respect to their personal income.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.