Dear Client:
This letter will give you a
brief overview of the new tax cut legislation and some perspective on how it could affect
your personal and business tax planning. The
focus is on provisions going into effect immediately or in 2002. However, a key feature of this law is that many
provisions are not slated to become fully effective for several years. Hence, we will touch upon these items to give you
a clearer view of the planning horizon.
The new law, officially
named the “Economic Growth and Tax Relief Reconciliation Act of 2001,” provides
the largest tax cut since 1981, mainly in the form of tax benefits for individuals. The lion’s share of these benefits is derived
from income tax rate reductions, an increase in the child tax credit, and the gradual
repeal of the federal “death taxes.”
Another significant part of
the legislation offers greater retirement savings incentives, including increases in the
contribution limits to individual retirement accounts (IRAs) and employer-sponsored
retirement programs such as 401(k) plans. The
new law also includes several education-related tax benefits and individual alternative
minimum tax (AMT) relief.
The legislation reduces the
lowest rate by creating a new 10% rate bracket below the current 15% rate bracket,
effective retroactively to January 1, 2001. The
10% rate applies to the first $6,000 of taxable income for single filers, the first
$10,000 for heads of households, and the first $12,000 for joint filers. Since this new rate is five percentage points less
than the former lowest rate, and applies retroactively, the effect will be to reduce
individual federal income tax for 2001 by a maximum of $300 for single filers (5% of
$6,000), $500 for heads of households (5% of $10,000), and $600 for joint filers (5% of
$12,000).
Lawmakers decided to
implement the new 10% rate this year by means of a credit, as computed above, and having
the Treasury Department prepay the credit by issuing “advance refund” checks
before October 1 of this year to all eligible taxpayers who timely filed their 2000 tax
returns. Therefore, if you filed your
federal income tax return for 2000 by this year’s April 16 deadline, you may be
entitled to an “advance refund” check from the federal government. Taxpayers filing their 2000 income tax return
after this year’s April 16 deadline, even if they have valid extensions, will receive
their checks later in the fall. No checks are
to be issued, however, after December 31 of this year (or earlier, if the Treasury decides
on an earlier cut-off date for administrative reasons).
Congress mandated rate reductions in other tax brackets,
beginning after June 30, 2001. The wage
withholding tables will be revised accordingly.
The initial reduction will
be one percentage point. Thus, the 39.6%
rate will be reduced to 38.6%, the 36% rate to 35%, the 31% rate to 30%, and the 28% rate
to 27%. Further reductions are to occur in
succeeding years. Finally, in 2006, the tax
brackets are to be 10%, 15%, 25%, 28%, 33%, and 35%.
The legislation provides
temporary, but immediate, relief from the individual alternative minimum tax (AMT) by
increasing the exemption to $49,000 for joint filers (a $4,000 increase), $24,500 for
married taxpayers filing separately (a $2,000 increase), and $35,750 for other individuals
(a $2,000 increase) in 2001 through 2004.
Other provisions in this legislation, although not directly affecting the AMT, eliminate its adverse impact on the child tax credit, the adoption credit, and the earned income credit.
Child Tax Credit. The legislation retroactively increases the child
tax credit for 2001 from $500 per child to $600 per child.
The $600 limit is to apply through 2004, then increase in stages until reaching
$1,000 in 2010.
Adoption Expenses. The legislation permanently extends both the
adoption credit and the exclusion for employer-provided adoption assistance, which were
scheduled to expire after this year, and increases the maximum amount of each from $5,000
to $10,000. Perhaps more important for many
taxpayers, however, is that it raises the income level at which the benefits begin to be
phased out to $150,000 (versus $75,000 in 2001).
Dependent Care Credit. The legislation also provides more generous
dependent care credit limitations that will increase the maximum credit for many
taxpayers, but these provisions do not take effect until 2003.
The new law also promises
relief from the “marriage penalty,” but most affected taxpayers will have to
wait until 2005 to benefit.
One provision will increase
the standard deduction for joint filers by making it twice the amount available to single
filers. Another provision will stretch the
15% bracket for joint filers to twice the size for single taxpayers, thus taxing a greater
portion of joint filers’ income at 15% before subjecting their remaining income to
higher rates. These provisions will not begin
to take effect, however, until 2005. The
standard deduction provision is to be phased in over a five-year period and the 15%
bracket increase over a four-year period.
A provision that will begin
to take effect in 2002 (and be fully phased in after 2007) will increase the earned income
credit (EIC) available to joint filers by increasing the earned income phase-out amount. Another provision taking effect in 2002 will
simplify the EIC computation.
The new law contains several education-related benefits,
most of which will go into effect next year. Here’s
a brief summary.
Education IRAs. Beginning
in 2002, the legislation significantly expands and liberalizes the “Education
IRA.” Perhaps the most notable change is
an expanded definition of tax-free “qualified education expenses,” formerly
limited to post-secondary education, that includes similar expenses (e.g., tuition) for
attending elementary and secondary schools. The
new law also:
·
Increases the annual contribution limit to
$2,000 per beneficiary (from $500); and
·
Increases the phaseout range for joint filers
to twice the amount for singles, thus making the phaseout range for eligibility $190,000
to $220,000 of “modified adjusted gross income.”
Qualified Tuition Plans. Effective
in 2002, the legislation allows funds to be rolled over from one plan to another plan
maintained for the same beneficiary. The new
law also extends this program, currently restricted to State-sponsored plans, to
educational institutions (which may be private institutions) meeting certain requirements. Distributions to pay for qualified higher
education expenses will be tax-free beginning in 2002.
Tax-free distributions from private plans, however, will not be available until
2004. Only tuition credits or certificates
will be available from private plans.
·
Increases the income
phase-out range for eligibility, currently set at $40,000 to $55,000 of “modified
adjusted gross income” for single filers and $60,000 to $75,000 for joint filers. The new phase-out ranges will be $50,000 to
$65,000 (single filers) and $100,000 to $130,000 (joint filers), with inflation
adjustments after 2002; and
·
Eliminates the rule that
limits the deduction to interest paid during the first 60 months in which interest is
required.
Above-the-line Deduction
for Qualified Higher Education Expenses. Under
this temporary provision, applicable from 2002 through 2005, eligible taxpayers can deduct “qualified tuition and related
expenses,” as defined for purposes of the HOPE credit, without having to itemize or
be subject to the “miscellaneous itemized deductions” limitation. The maximum deduction is $3,000 in 2002 and 2003
and is limited to taxpayers having adjusted gross incomes (as specially defined) of up to
$65,000, or, for joint filers, $130,000.
Increases in IRA
Contribution Limits. Beginning in 2002,
the legislation increases the contribution limits for IRAs and creates a new
“catch-up” rule that raises the contribution limits for people aged 50 and above
by an additional $500. The new contribution
limits for traditional and Roth IRAs will be $3,000 in 2002 and will gradually increase to
$5,000 in 2008, with indexing in $500 increments thereafter.
·
Increases the limit on annual compensation
that may be taken into account for determining, among other things, contributions and
benefits under a qualified plan, to $200,000 (from $170,000), with indexing in $5,000
increments thereafter;
·
Increases the limit on
annual additions to a defined contribution plan to $40,000 (from $35,000), with indexing
in $1,000 increments thereafter;
·
Increases the limit on annual benefits that
may be received under a defined benefit plan to $160,000 (from $140,000), with inflation
adjustments thereafter in $5,000 increments, as under current law;
·
Increases the dollar limit on elective
deferrals under section 401(k) plans, tax-sheltered annuities (“section 403(b)
annuities”), and salary reduction simplified employee pension plans
(“SEPs”) to $11,000 (from $10,500). The
limit is to increase in $1,000 increments in later years until it reaches $15,000 in 2006,
with indexing in $500 increments thereafter;
·
Increases the dollar limit on annual
deferrals under “section 457 plans,” i.e., deferred compensation plans of state
or local governments or tax-exempt organizations, to $11,000 (from $8,500). The limit is to increase in $1,000 increments in
later years until it reaches $15,000 in 2006, with indexing in $500 increments thereafter;
·
Increases the dollar limit on annual elective
deferrals to a SIMPLE plan to $7,000 (from $6,500). The
limit is to increase in $1,000 increments in later years until it reaches $10,000 in 2005,
with indexing in $500 increments thereafter.
The legislation technically
repeals the federal “death taxes,” but provides a decade-long phase-in period,
several changes to the current rules in the interim, and a “carryover basis”
provision that is sure to cause confusion and potentially unpleasant income tax
consequences to the beneficiaries of many estates. Moreover,
further changes in the rules are almost a certainty.
Here are a few key points to
keep in mind.
·
The repeal applies to the federal estate and
generation-skipping taxes. It does not repeal
the federal gift tax. Also, the
legislation does not eliminate any state “death taxes”;
·
Complete repeal will not occur until 2010;
·
Death tax repeal may eliminate the income tax
savings achieved through a “step up” in the basis of property received from a
decedent. As a result, families may not be
able to take advantage of the potential benefits of death tax repeal without careful
planning.
All estate tax plans,
especially those involving trusts, should be reviewed with your estate planner as soon as
possible.
Technically, the changes
made by the new law, including the “death tax repeal,” will cease to apply
after 2010! This highly unusual
provision was included to insure technical compliance with the federal budget law. The lawmakers obviously assume that this provision
will be eliminated in future legislation.
Please feel free to arrange
an appointment to discuss any of these changes and their impact on your tax planning
strategies.
Sincerely,
Edmundson & Company, CPAs