It's that time again for most American taxpayers. The deadline for filing 2006 returns looms close (April 17th this year).  Many of the tax breaks in recent tax-relief bills were designed to be phased in over a number of years or are indexed to inflation.  This article explains the changes that come into effect for tax year 2006.

Starting in 2006

Increased Retirement Contribution Limits.  The caps on contributions to many types of plans have risen for 2006:

• The maximum 401(k) and 403(b) employee contribution increases to $15,000.

• Taxpayers who are at least age 50 before the end of 2006 can make additional contributions (called catch-up contributions) over and above the basic ceiling for the following plans:

  • An additional $5,000 for 401(k), 403(b), salary reduction SEP plans, and 457 plans

  • An additional $2,500 for SIMPLE plans

  • An additional $1,000 for IRAs (both traditional and Roth IRAs)  

Higher Income Limits for Deductible IRAs.  If you are covered by a retirement plan at work, you can take a full IRA deduction if your modified adjusted gross income is $75,000 or less if you are married filing jointly or $60,000 or less if you are single or a head of household. A partial deduction is allowed until your adjusted gross income reaches $85,000 if you are married filing jointly or $70,000 if you are single or a head of household.

A Tougher "Kiddie" Tax.  Until the year that a child reaches 18, any unearned income over $1,700 will be taxed at the parents' marginal rate, not the child's. Before this year, the rule applied only to kids who were under 14.

Foreign Earned Income.  Although the foreign earned income exclusion is increased to $82,400 this year (up from $80,000), the maximum housing cost exclusion is reduced substantially. And, in a tricky calculation, earnings above these exclusions are taxed at higher rates instead of starting out in the lowest bracket.

New Credit for Nonbusiness Energy Property.  For 2006 and 2007, you may claim a lifetime credit of $500 (only $200 of which can be for windows) for making qualifying energy-saving improvements to your principal residence. Qualifying expenditures include installation of certain energy-efficient insulation materials, exterior windows and doors, electric heat pumps, and central air conditioning. The credit is 10 percent of the cost of qualifying materials.

New Credit for Residential Energy-efficient Property.  For 2006 and 2007, you may claim a $2,000 credit for the installation of solar water heating equipment, photovoltaic or fuel cell equipment in your primary residence or a second home. The credit is 30 percent of the cost of the equipment. No credit is allowed for equipment used to heat a swimming pool or hot tub.

New Credit for Purchase of New Energy-efficient Vehicles.  Beginning in 2006, you can claim a tax credit for purchasing a hybrid vehicle.  This replaces the $2,000 Clean Fuel Deduction, which expired at the end of 2005.  The credit is better because it reduces your tax liability dollar-for-dollar. New hybrid vehicles are eligible for a tax credit up to $3,400, depending on their fuel efficiency.  This credit is limited, however, to the first 60,000 vehicles sold after 1/1/06 per auto manufacturer.  This cap already affects Toyota and Lexus hybrids.  Those purchased after September 30, 2006, receive half the credit available for those bought earlier in 2006.  Starting in April, 2007, the credit for these hybrids will be cut in half again.  A new tax credit also is available for other alternative fuel vehicles.

Increased Section 179 Deduction.  The maximum amount that businesses can deduct in lieu of depreciation increases from $105,000 to $108,000 for assets placed in service in 2006.  This is often called the "expensing" deduction.

Estate Tax Exemption.  In 2006, the federal estate tax exemption rises to 2,000,000, up by $500,000 from 2005.

Tuition and Fees Deduction.  This deduction for up to $4,000 of college tuition and fees expired for tax years after 2005.

Educators' Deduction.  This deduction for up to $250 of teachers' classroom supplies expired after 2005, but it's expected that Congress will reinstate it retroactively to be available for 2006 returns.

Sales Tax Deduction.  The opportunity for itemizers to choose to deduct their state sales tax payments instead of deducting their state and local income taxes expired at the end of 2005.  However, it is expected that Congress will reinstate it retroactively to be available for 2006 returns.

Reduction in Itemized Deductions and Personal Exemptions for High-income Taxpayers.  Currently, itemized deductions and personal exemptions are phased out (reduced) as your income rises.  The reduction of itemized deductions occurs once your adjusted gross income exceeds $150,500, regardless of your filing status.  The reduction in personal exemptions begins at $225,750 of adjusted gross income for married filing jointly, $188,150 for head of household, and $150,500 for single.  Starting in 2006, the amount of the deduction phaseouts will be reduced by one third.  In 2008, they will be reduced by two thirds, and in 2010, the phaseouts will be eliminated altogether.

Gift Tax Annual Exclusion Increased.  In 2006, the annual amount of cash you can give to someone else without being required to file a gift tax return increases from $11,000 to $12,000.

Nontaxable Combat Pay Allowed for Earned Income Credit.  You can make an election to include nontaxable combat pay in the calculation of earned income for the earned income credit.  This provision was previously set to expire at the end of 2005, but has been extended to include 2006.

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