Profit from hidden pluses in new tax law

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in Small Business Tax,Small Business Tax Deduction Strategies

Much of the media attention on the new tax legislation passed by Congress focused on extending the tax breaks on capital gains and dividends. But the new law also contains a few tax surprises for small business owners.

In short, the new tax law is a good news/bad news story.

Good news: If you’ve been blocked from converting your traditional IRA to a Roth IRA due to your high income, you can look forward to a big change. Starting in 2010, anyone will be able to convert to a Roth IRA, not just those with incomes below $100,000.

Bad news: It will be more difficult for you to reduce the tax bite on investment income earned by your teenagers. Reason: The new law raises the age threshold for the dreaded “kiddie tax” to 18.

Let’s take a closer look at these two important tax law changes.

1. Income cap lifted on Roth IRA conversions. Unlike a traditional IRA, you can’t deduct your contributions to a Roth IRA. But Roths carry an even better deal: While you pay taxes on the money going into a Roth, funds grow tax-free and can be withdrawn tax-free, too. Plus, you don’t have to take mandatory withdrawals from a Roth once you reach a certain age.

If you convert your traditional IRA to a Roth IRA, you’d have to face a one-time tax hit on the built-up appreciation. But then, those funds can grow tax-free.

The problem: You can make the IRA-to- Roth conversion only if your adjusted gross income (AGI) falls below $100,000.

The new law eliminates that income threshold starting in 2010.

Expect the change to open the floodgates for Roth conversions by affluent taxpayers.

Strategy: If your high income has shut you out of a Roth IRA, continue to pile up money in your traditional IRAs. It may even make sense to make nondeductible contributions in these intervening years. Then, in 2010, move all of those funds to a Roth IRA, pay the tax hit and start reaping tax-free gains and withdrawals. (Note: The new law allows people converting in 2010 to spread the resulting tax over three years.)

2. Less favorable tax rate on teen income. Under the kiddie-tax rules, a child’s unearned income above a specified limit ($1,700 for 2006) is taxed at the top marginal tax rate of the child’s parents.

Many parents put stocks in their teenage children’s accounts to try to take advantage of the child’s lower tax rate.

Prior to the new law, that tax rule applied to children under the age of 14. But the new law says a child’s investment income will still be taxed at the parents’ high marginal tax rate until the child turns 18. Only then would the child’s investment income be taxed at his or her lower rate.

Strategy: Continue using tax techniques for lowering the kiddie tax (see our Feb. 6, 2006 issue). For instance, you might use growth stock to defer tax to future years or invest in tax-free municipals or munibond funds.

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