The Tax Planning Environment in 2016

While more than 15 major pieces of tax legislation have been enacted into law since 2000, the current tax planning environment has been heavily shaped by the American Taxpayer Relief Act of 2012, passed in January 2013, and the Protecting Americans from Tax Hikes (PATH) Act of 2015, passed late last year.

Together, these legislative acts made permanent several significant tax provisions that had previously existed only in temporary form, and introduced new rates and limitations that target high-income individuals. But while a host of popular tax benefits commonly referred to as “tax extenders” are now permanent fixtures in the tax code, others were simply extended, some only through the 2016 tax year. As a result, 2016 tax planning takes place in a relatively stable tax environment, with some small degree of uncertainty regarding the potential availability of specific provisions heading into the 2017 tax year.

Permanent provisions

These provisions are now part of the permanent tax landscape:

  • The six-individual federal income tax rates (10%, 15%, 25%, 28%, 33%, and 35%) that had existed in temporary status for more than a decade, and a top 39.6% tax rate that applies to those with the highest incomes
  • Special maximum tax rates generally apply to long-term capital gains and qualified dividends; the rate is 0%, 15%, or 20% depending on your federal income tax bracket
  • Higher alternative minimum tax (AMT) exemption amounts are in effect and adjusted for inflation; the AMT is essentially parallel federal income tax system with its own rates and rules, and the higher exemption amounts and other related provisions significantly limit the reach of this tax
  • Personal and dependency exemptions phase out at higher incomes, and itemized deductions may be limited
  • “Marriage penalty” relief is now permanenting the form of an increased standard deduction for married couples and an expanded 15% federal income tax bracket
  • Expanded tax credit provisions relating to the dependent care tax credit, the adoption tax credit, and the child tax credit
  • Increased limits and more generous rules of application relating to certain education provisions, including Coverdell education savings accounts, employer-provided education assistance, and the student loan interest deduction
  • Individuals age 70½ or older can make qualified charitable distributions (QCDs) from their IRAs, and exclude the distribution from gross income (up to$100,000 in a year); QCDs count toward satisfying any required minimum distributions (RMDs) that would otherwise have had to be made from the IRA
  • Individuals who itemize deductions on Schedule A of IRS Form 1040 can elect to deduct state and local general sales taxes in lieu of the deduction for state and local income taxes
  • The maximum amount that can be expensed by a small business owner under IRC Section 179 rather than recovered through depreciation deductions is$500,000, reduced by the amount by which the cost of qualifying property placed in service during the year exceeds$2,010,000 (2016 figures; will be adjusted for inflation in future years)

Roth IRA Conversions

With the lure of tax-free distributions, Roth IRAs have become increasingly popular retirement savings vehicles. According to the 2015 Investment Company Fact Book, 19.2 million U.S. households (about 15.6%) owned Roth IRAs in 2014.

What are the general rules for funding Roth IRAs?

There are three ways to fund a Roth IRA–you can contribute directly, you can convert all or part of a traditional IRA to a Roth IRA, or you can roll funds over from an eligible employer retirement plan. In general, you can contribute up to $5,500 to an IRA (traditional, Roth, or a combination of both) in 2016 ($6,500 if you’ll be age 50 or older by December 31). However, your ability to make annual contributions may be limited (or eliminated) depending on your income level (“modified adjusted gross income,” or MAGI), as shown in the chart below:

If your federal filing status is:

  • Single or head of household
  • Married filing jointly or
  • Qualifying widow(er)
  • Married filing separately

Your 2016 Roth IRA contribution is reduced if your MAGI is:

  • More than $117,000 but less than $132,000
  • More than $184,000 but less than $194,000
  • More than $0 but less than $10,000

You can’t contribute to a Roth IRA for 2016 if your MAGI is:

  • $132,000 or more
  • $194,000 or more
  • $10,000 or more

Unlike a traditional IRA, you can contribute to a Roth IRA even if you’re 70½ or older. However, your contributions generally can’t exceed your earned income for the year (special rules apply to spousal Roth IRAs).

Important changes since 2010

Prior to 2010, you couldn’t convert a traditional IRA to a Roth IRA (or roll over non-Roth funds from an employer plan to a Roth IRA) if your MAGI exceeded $100,000 or you were married and filed separate federal income tax returns. The Tax Increase Prevention and Reconciliation Act (TIPRA), however, repealed the $100,000 income limit and marital status restriction, beginning in 2010. What this means is that, regardless of your filing status or how much you earn, you can convert a traditional IRA to a Roth IRA. (There’s one exception–you generally can’t convert an inherited IRA to a Roth. Special rules apply to spouse beneficiaries.)

And don’t forget your SEP IRAs and SIMPLE IRAs.

They can also be converted to Roth IRAs (for SIMPLE IRAs, you’ll need to participate in the plan for two years before you convert). You’ll need to set up a new SEP/SIMPLE IRA to receive any additional plan contributions after you convert.

How do you convert a traditional IRA to a Roth?

Converting is relatively simple. You start by notifying your existing traditional IRA trustee or custodian that you want to convert all or part of your traditional IRA to a Roth IRA, and the custodian/trustee will provide you with the necessary paperwork. You can also open a new Roth IRA at a different financial institution, and then have the funds in your traditional IRA transferred directly to your new Roth IRA. The trustee/custodian of your new Roth IRA can give you the paperwork that you need to do this. If you prefer, you can instead contact the trustee/custodian of your traditional IRA, have the funds in your traditional IRA distributed to you, and then roll those funds over to your new Roth IRA within 60 days of the distribution. The income tax consequences are the same regardless of the method you choose.