Washington Taxpayers who put their money into energy-saving home improvements and hybrid vehicles in 2006 will reap big rewards next year at tax time: new tax credits, among the tax code's most potent gifts.
Though Congress' dithering with the alternative minimum tax poses some challenges for those who like to plan their tax year in advance, there's no doubt that energy-conserving moves make smart tax sense for 2006.
Replacing the tax deduction for hybrid vehicles, which expired at the end of 2005, is a tax credit, a bigger benefit. Deductions only reduce the income against which tax is assessed, while credits are a dollar-for-dollar reduction in tax liability.
Taxpayers who buy or lease a new hybrid gas-electric car or truck in 2006 are eligible for a credit of $250 to $3,400 per vehicle, depending on its fuel economy and weight. Because there are long waiting lists to get such vehicles, people who ordered hybrids in 2005 can claim the credit for the 2006 tax year, as long as they did not take possession of the vehicle before Jan. 1, 2006.
Homeowners who install new energy-saving devices like solar water heaters or rooftop solar panels are eligible for an energy credit of up to $2,000 per system. Certain insulation, heat pumps, air conditioners and furnaces can qualify for a credit of up to 10 percent of their cost, to a total maximum lifetime credit of $500.
"The first thing I would do is think about any necessary improvements to your home because we have the opportunity for an energy-efficient credit. It applies to everything from new storm windows and doors to more energy-efficient furnaces," said Maggie Doedtman, tax advice specialist at H&R Block.
Saving for retirement, always a good idea, receives more favorable tax treatment in 2006, with higher contributions to qualified retirement plans permitted. Additional "catch-up" contributions for taxpayers over 50 also rise by between $500 and $1,000, depending on the type of plan.
That means taxpayers should try to contribute the maximum allowable this year, starting as soon as possible so that savings can build over the course of the year.
Another important task for early 2006 is deciding whether the right amount of tax is being withheld from your paycheck. Taxpayers due refunds for 2005 should realize that the government has essentially had free use of that money for much of the past year, notes John Battaglia, director of Deloitte & Touche's private client adviser division.
"If you're getting a significant refund, you're probably withholding too much, and you're giving the government an interest-free loan," Battaglia said.
Those taxpayers should file a new W-4 form in 2006 decreasing the amount of tax withheld. Similarly, those who owe tax for 2005 should have more withheld in 2006.
And beginning in 2006, taxpayers who contribute to a 401(k) plan may designate some or all of those contributions as "Roth" contributions, if their employer plan permits. Such contributions are included in taxable income in the year they are made.
But Roth distributions later in life - when, presumably, they are needed - aren't taxed, so taxpayers who think they will be in a higher tax bracket at retirement may want to make Roth contributions in 2006.