The Rules Have Changed:
How the Tax Relief Act of 2005 May Affect You

By Douglas Charney

If you’re more like most people, you’re probably looking for ways to minimize your tax liability. After all, no one wants to hand over more than is legally necessary of their hard-earned money to the government. The good news is that the Tax Relief Act of 2005, adopted by Congress in 2006, may be of benefit to you and enable you to potentially lower your taxes while you save more for your future.

Unfortunately, most people are not aware of how beneficial the Tax Relief Act of 2005 can be. They mistakenly believe it doesn’t apply to them, so they don’t bother seeking out information on the topic. In reality, the Tax Relief Act of 2005 affects many in some way. If you’re one of the millions of people who participate in a 529 plan, Roth 401 (k), IRA plan or traditional 401 (k), here are some highlights of how the Act can benefit you. (Note: While the Tax Relief Act of 2005 addresses many more topics, this article will only focus on the three mentioned.)

529 College Savings Plan: In the past, many people considered the 529 College Savings Plan the best education savings tool available. With the Tax Relief Act of 2005, I believe the 529 Plan got even better.     The money saved in a 529 can be used to cover almost any educational expense, including tuition, room, board, books and supplies. Prior to the Tax Relief Act of 2005, the ruling that withdrawals were tax exempt was set to expire in 2010. Now, that deadline has been removed and all 529 plan withdrawals, today and well into the future, are free of federal income tax. Additionally, many states have enacted rules that all gains in 529s are exempt from state taxes too.

If you have put off starting a 529 plan for your child or grandchild because of the old 2010 withdrawal deadline, you can rest assured that your contributions will retain their tax advantage status. Now you can perhaps save for your child’s education while potentially lowering your tax burden at the same time.

Please consider the investment objectives, risk, charges and expenses carefully before investing in a Series 529 College Savings Plan. The official statement, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest.

Investors should consider, before investing, whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s 529 college savings plan. The availability of such tax or other benefits may be conditioned on meeting certain requirements.

Roth 401 (k): The Tax Relief Act of 2005 made the Roth 401 (k) Plan permanent, eliminating the sunset provision that had such plans expire in 2010. In case you haven’t heard of the Roth 401 (k), here’s the scoop. The big difference between the Roth 401 (k) and traditional 401 (k)s is when your money is taxed. With a traditional 401 (k), your money is not taxed until you start withdrawing it at retirement. For example, if you make $45,000 next year and contribute $3,000 to your traditional 401 (k), you will only be taxed on $42,000 of annual income. However, if you contribute $3,000 this year to a Roth 401 (k), you still have to pay taxes on $45,000 of income. You don’t get a tax break now. When you retire though, you can withdraw your money from the Roth 401 (k) and keep all of it, because you have already paid taxes on it.

The Roth 401 (k) went into effect January 2006, but few people have taken advantage of it, partly because of the uncertainty of its future tax treatment. Now that Washington has made the plans permanent, expect to see more mention of them in the workplace. They are an especially valuable plan for younger workers, those who are in a lower income tax bracket now, but may be in a much higher one when they retire. So while you may actually lose a small amount of tax savings now, you gain a big advantage when you withdraw the money during retirement.

401 (k) and IRA Contributions: Among the most widely praised changes in the Tax Relief Act are the increases in annual 401 (k) and IRA contributions. Prior to the Tax Relief Act, the maximum annual contributions were $2,000 per year to IRAs and $10,500 to a 401 (k). Now those limits are increased to $4,000 per year for IRAs with a $1,000 catch-up to anyone over age 50, and $15,000 per year for 401 (k) with a $5,000 catch-up for those over 50.

While that may not seem like a hug increase, look at it this way. For example, if you’re a married couple over age 50, you can each put $5,000 into a traditional IRA. That’s $10,000 socked away for retirement. If that couple earned $30,000 that year, their federal income tax would only be on $20,000. That could equal as much as a saving of $1,500 in federal income tax.

Other notable changes include penalty free hurricane related distributions and hurricane related plan loans for those people who affected by Hurricane Katrina. And if you’re in the military receiving combat pay (wages you don’t pay taxes on), that combat pay now counts as compensation for IRA contributions.

Finally, with the tax Relief Act, employees can now automatically enroll new workers into the 401 (k) plan, starting in 2008. Of course, employees still have the right to opt out of the plan, if they wish, but studies show most employees don’t opt out. I believe this automatic enrollment should lead to better 401 (k) participation, which is critical as more companies use their plans to replace traditional pension plans.

Plan Today for Better Tomorrow: The Tax Relief Act of 2005 has many more guidelines. The ones covered here simply provide an overview of how the changes affect the average investor. If you thought the Tax Relief Act of 2005 didn’t affect you, think again. Now may be a good time to contact your accountant and your financial advisor to ensure the new rules keep you a winner in the most important game of all, managing your life.

Read other articles and learn more about Douglas T. Charney.

The solutions discussed may not be suitable for your personal situation, even if they are similar to the example presented. Investors should make their own decisions based on their specific investment objectives and financial circumstances. It should not be assumed that the recommendations made in these situations achieved any of the goals mentioned. These examples are hypothetical and do not represent any specific investments or strategies.  Wachovia Securities does not render legal or tax advice. The accuracy and completeness of this article are not guaranteed. The opinions expressed are those of the author and are not necessarily those of Wachovia Securities or its affiliates. The material is distributed solely for informational purposes and is not a solicitation or an offer to buy any security or investment or to participate in any trading strategy. Provided by courtesy of Douglas Charney, a Vice President- Investments with Wachovia Securities in Harrisburg, PA. For more information call him at 888-529-2973. Wachovia Securities, LLC, member New York Stock Exchange and SIPC, is a separate nonblank affiliate of Wachovia Corporation, 2007 Wachovia Securities LLC.

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