Guide to the Tax Act of 2001: the economic growth and Tax Relief Reconciliation Act of 2001.
by Thomas Boyd The Tax Act of 2001 is a $1.35 trillion package that significantly overhauls the tax system over the next decade. Its provisions affect all individual taxpayers, and present an array of tax Planning strategies and opportunities. There are tax rate cuts, estate tax relief pension plan enhancement, and education incentives. However, the Act does create complexity and uncertainty. Introduction On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (HR-1836 P.H. 107-16). This act represents one of the most sweeping tax changes and cuts in more than 20 years. Its provisions affect all individual taxpayers, and present an array of tax planning strategies and opportunities. It also comes with pitfalls and challenges that taxpayers can ill afford to overlook. President Bush campaigned on his vision of what to do with a projected government surplus over the next decade. His plan included allocating $1.6 trillion to tax relief. This bill is a result of that vision, and contains $1.35 trillion in tax cuts over the next 10 years. Many of the provisions of the bill are phased in over a number of years, with some taking effect immediately, and others stretching out to 2010. There is a "sunset" provision, which means that unless Congress reaffirms the bill's provisions, all changes will terminate after December 31, 2010. No doubt this guarantees future action on taxes by Congress. The act contains almost 100 major provisions, and is primarily of benefit to individual taxpayers. The majority of these provisions fall into four areas of importance to individual taxpayers: Personal Tax Reduction * Reduction in marginal tax rates * Relief from marriage penalty * Repeal of the phase-out of the personal exemption and itemized deductions * Increase in the child-care tax credit * Increase in dependent-care credit Education Relief * Modification to Education IRAs * Changes in Qualified Tuition Programs ("Section 529 Plans") * Modification to student loan interest * Extension of employer-provided educational assistance to include graduate studies * Qualified higher education deduction Estate and Gift Tax Relief * Increase in estate, gift, and generation-skipping transfer exclusion amounts * Decrease in estate and gift tax rates * Repeal of estate and generation-skipping transfer tax Retirement Plan Enhancement * Increase in annual IRA contributions limits * Increase in allowable contributions to qualified retirement plans * Catch-up provisions that allow higher contributions for taxpayers 50 and over * Greater flexibility with respect to distributions and rollovers This list is certainly not all-inclusive of the new tax provisions in the 2001 tax act, nor will this discussion be able to cover all the rules or complexity of these tax changes. Its purpose is rather to highlight the most significant changes, and provide readers with a guide to help plan for them. Be warned that, in all probability, any tax bill that covers a period of ten years will see many changes. Some of these provisions will be changed before they ever come into effect Others will terminate if Congress does not act before 2010 to make the enacted provisions permanent This is of particular importance, since most of the tax relief comes in the last five years of the tax bill. Also, as we shall discuss, some of the tax relief may be illusory for many taxpayers. That is, they may get a tax reduction due to a lowering of marginal tax rates, but lose the benefit due to the consequence of the alternative minimum tax. Personal Tax Reduction Personal tax relief was the primary objective of the 2001 tax legislation. There was a difference of opinion on who should get the relief and in what format it should be given. Republicans favored across-the-board tax reduction, with elimination of some of the inequities in the current tax structure, most notably the marriage penalty. Democrats were concerned that this would mean that most of the tax relief would go the wealthiest taxpayers. They proposed lowering the rates more at the lowest tax brackets, and increasing the child credit and earned income credit The 2001 Tax Act is a compromise of each of these approaches. New Marginal Income Tax Rates. The centerpiece of the tax relief act is the reduction of the marginal tax rates for individuals. This was the most expensive provision of the tax bill, giving an estimated $958 billion in tax relief. President Bush and Congress wanted to return some of the current budget surplus to taxpayers, and felt that an immediate tax cut was necessary to stimulate the economy. To accomplish this, a new 10% bracket, carved out of the lower portion of the existing 15% bracket, was introduced in 2001,,. Other tax brackets are also reduced gradually starting in 2001; the reduced brackets will be fully phased in by 2006. The new 10% bracket encompasses the first $6,000 ($7,000 after 2007) of taxable income for singles, and the first $12,000 ($14,000 after 2007) for married couples filing jointly. Most taxpayers will receive this benefit in the form of a refund check from the IRS before the end of 2001. If the taxpayer paid taxes in 2000, he or she will receive a check ranging from $300 for a single person to $600 for a married couple. The tax rate schedules for 2001 will not reflect the 10% rate, because most taxpayers will have already received a refund check giving them the benefit of this new rate. If any taxpayers do not receive a check, for whatever reason, they will then get a credit against their 2001 income tax liability. Taxpayers receiving checks in 2001, but not owing taxes for that year, will not have to refund the amounts. The table below compares the current marginal income tax rates with the new rates: | |
Present 2001 2002-2003 2004-2005 2006-2010
Law
28% 27.5% 27% 26% 25%
31% 30.5% 30% 29% 28%
36% 35.5% 35% 34% 33%
39.6% 39.1% 38.6% 37.6% 35%
| | Note: The new 10% income tax bracket allocates a portion of the taxpayers' income that had previously been taxed at 15%. The phase-in of lower marginal tax rates does offer some tax planning opportunities. Taxpayers should attempt to defer the recognition of income to later years, when the tax rates will be lower. For example, exercising stock options that result in the recognition of ordinary income might be deferred. Similarly, taxpayers should consider accelerating the payment of tax-deductible expenses to offset taxable income at higher rates. Real estate taxes or contribution payments could be accelerated to give higher deductions in a given year. However, caution must be exercised in doing so. It's necessary to consider the alternative minimum tax consequence, as well as the repeal of itemized deduction phase-out limitations. Alternative Minimum Tax Consequence. The alternative minimum tax (AMT) is imposed on individuals to the extent that it exceeds the regular tax. AMT is generally the sum of 26% of the first $175,000 of Alternative minimum taxable income (AMTI), and 28% on any excess. AMTI is computed by taking taxable income and adding back the personal exemption deduction, standard deduction, or certain itemized deductions such as taxes and employee business expenses, specific tax preferences and adjustments less an exemption amount The exemption amount is $45,000 for married couples and $33,75) for single or head of household taxpayers. There is a phase-out range for this deduction, whereby married taxpayers start losing the deduction when their AMTI exceeds $150,000 and completely lose the deduction when their AMTI reaches $330,000. The single and head of household range is $112,500 to $247,500. The only relief that the 2001 Tax Act gave for the AMT was to increase the exemption amount by $4,000 for married couples, and $2,000 for single or head of household filers. In 2005 the exemption amounts are scheduled to return to their 2000 levels. This ail 1 means that many more taxpayers will find themselves becoming subject to AMT, which will offset some of or all of the benefit they receive from lower marginal tax rates Taxpayers most affected by AMT will be those with taxable income between $100,000 and $700,000. A significant number within this group will be subject to the alternative minimum tax. Relief from the Marriage Penalty. The 2001 Tax Act contains a number of provisions designed to help alleviate the penalty that arises when the combined tax liability of a married couple filing a joint return is greater than the combined tax they would pay if they were not married and filing singly. This relief is accomplished by: * Increasing the standard deduction, beginning in 2005. In 2009, when the increase is fully phased n, the standard deduction for taxpayers filing a joint return will be twice the standard deduction for an individual filing a single return. * Increasing the size of the 15% bracket for married couples over the period 2005 to 2008. * Increasing the phase-out point for the earned income credit over seven years, starting in 2002. Repeal of Personal Exemption and Itemized Deduction Phase-outs. Individual taxable income is computed by taking an individual's adjusted gross income and subtracting exemptions and either the standard deduction or allowed itemized deductions. A taxpayer is allowed one personal exemption for himself or herself, and one for his or her spouse if filing a joint return. An exemption is also allowed for each qualified dependent. The number of exemptions is multiplied by an exemption amount, which is $2,900 for the year 2001. Itemized deductions include unreimbursed medical and dental expense (to the extent that the amount exceeds 71/2% of AGI), state and local income taxes, real estate taxes, home mortgage interest, investment interest expense, recognized charitable contributions, personal casualty and theft losses (subject to limitations), and employee business and miscellaneous expense (to the extent the amount exceeds 2% of AGI). For high-income-tax individuals (those whose adjusted gross income exceeds specified amounts), the deduction for both personal exemptions and itemized deductions is limited. The phase-out threshold for the tax year 2001 starts at: | |
Filing Status Personal Exemptions Itemized Deductions
Married $199,450 $132,950
Head of household 166,200 132,950
Single 132,950 132,950
| | This limitation on high-income taxpayers will be repealed over a five-year period beginning in 2006. By the year 2010, there will be no reduction on the amount a taxpayer can deduct for personal exemptions or itemized deductions. Increase in Child Tax Credit. Taxpayers who have dependents under the age of 17, and who meet certain income thresholds, are entitled to the child tax credit. The credit provides a dollar for dollar reduction against income tax liability. This credit increases from $500 to $600 for the years 2001-2004, $700 for years 2005-2008, then rises to $800 in 2009, and $1,000 in 2010. The credit phases out at the rate of $50 for every $1,000 (or fraction thereof) that modified adjusted gross income exceeds $110,000 for married couples filing jointly, and $75,000 for singles and heads of household. The phase-out ranges are indirectly increased because of the increase in the credit. Thus, for the year 2001, the child tax credit begins at $110,000 for a married taxpayer filing jointly and ends at $121,000 if the taxpayer has one child or $133,000 for two children. Once modified gross income exceeds the limits, no credit is allowed. Increase in Dependent Care Credit. A credit against a taxpayer's income tax liability is available to individuals who incur and pay child and/or dependent care expenses during the year. The credit is a percentage of dependent and/or child-care expenses, subject to limitations. Both the dependent-care expense eligible for credit; and the credit percentage, will increase. Effective for tax years beginning in 2003, the maximum amount of dependent care eligible for the credit will increase from the current $2,400 to $3,000 for one eligible dependent, and from $4,800 to $6,000 for more than one. At the same time, the credit percentage will increase from the current 30% to 35%. However, since the credit percentage is reduced 1% for each $2,000 (or fraction thereof) of adjusted gross income above $15,000, with a maximum reduction of 15%, most taxpayers' credit will be 20% of eligible dependent-care expenses. Education Relief The new law may have a significant effect on education savings plans as a result of changes to Educational IRAs and qualified tuition programs known as "Section 529 Plans." Some of the new provisions ease the cost of higher education by providing new and expanded deductions and exclusions. Modification to Education IRAs. The annual limit on contributions to Education IRAs increases from $500 to $2,000, effective for tax years beginning in 2002. While contributions to an Educational IRA are non-deductible, any distributions from the IRA are tax-free to the beneficiary so long as they are used for qualified education expenses. The definition of qualified education expenses has been expanded. It is no longer limited to higher education, alone. Now it also includes elementary and secondary school expenses. Tuition, fees, books, room and board, supplies, tutoring, and required equipment are included as qualified expenses. There is an adjusted gross income limit, but this also has been increased to a range of $190,000 to $220,000 for joint filers, and $95,000 to $110,000 for single filers. No restriction exists on who can contribute to an Education IRA on behalf of a designated beneficiary. Therefore, relatives, friends, or even the designated beneficiary could contribute to an Educational IRA. The aggregate contributions on behalf of any beneficiary are limited to $2,000 for each year. Changes in Qualified Tuition Programs. The Act does two things. It allows the exclusion of income earned under state tuition programs (Sect 529 Plans), and expands the range of higher educational institutions to include private colleges and universities. The major change in these plans starts in 2002 when distributions from the plan for qualified higher education expenses may be excluded from the taxpayer's gross income. The expenses that can be covered under these plans are generally the same as those for Education IRAs. An advantage of Section 529 Plans over Educational IRAs is that large amounts may be contributed to these plans. They are not limited to $2,000 as in Education IRAs. There are no income limitations, no established age of beneficiary in setting up Section 529 Plans, and no mandatory distribution age. An Education IRA has income limitations, can't be set up after the beneficiary attains age 18, and must be distributed by the time the beneficiary reaches age 30. In Section 529 Plans, the donor has more control over the funds. Donors maybe owners of the plan, and retain the ability to change the beneficiary as well as withdraw unused plan assets. If the donor takes money back from the plan, earnings will be taxable. Student Loan Interest. Effective for tax year 2002, the Act allows student loan interest to be deductible beyond the first 60 months in which interest payments are required. It also increases the income level at which eligibility for the deduction begins to phase out. Currently, single filers lose the deduction if their adjusted gross income exceeds $55,000; this will increase to $65,000 in 2002. Married taxpayers filing jointly currently lose the deduction at $75,000; this will increase to $130,000. Employer-Provided Educational Assistance. Education expenses paid by an employer for an employee are deductible by the employer and not included in the employee's gross income if the education is work-related. Section 127 provided that even if the education is not work-related, it could still be excluded from the employee's gross income up to $5,250 a year. This provision covered only undergraduate tuition, and was to expire at the end of 2001. The Tax Relief Act of 2001 extended the exclusion to cover graduate education, and makes the exclusion permanent. This is effective January 1, 2002. Deduction for Higher Education Expenses. Effective for tax years beginning in 2002, there will be an above-the-line deduction for qualified higher education expenses. The deduction covers tuition and fees paid by taxpayers for themselves, spouses or dependents. In 2002 and 2003 the maximum deduction allowed is $3,000 for taxpayers whose modified AGI does not exceed $65,000 if their filing status is single, or $130,000 if married filing jointly. The deduction increases to $4,000 for the years 2004-2005. No deduction is permitted in 2006 and thereafter. Estate and Gift Tax Relief During the presidential campaign, George W. Bush called for the repeal of the so-called death tax. The Act does provide for a gradual reduction in estate taxes, its repeal for one year, then its reinstatement Under the new legislation, the size of estates exempted from the tax is increased from $1 million in 2002 to $3.5 million in 2009; the tax is then repealed, but only for one year. As a result, estate tax planning will become more complex and uncertain. Death and Taxes. Beginning in 2002, the Act will gradually increase the number of estates exempt from the tax, reduce the estate, gift, and generation-skipping transfer (GST) tax rates. It also made many more technical changes. Currently there is a unified credit that excludes $675,000 of the estate's net assets from tax. This amount increases to $1 million in 2002-2003, $1.5 million in 2004-2005, $2 million in 2006-2008, and $3.5 million in 2009. The estate tax will be repealed in 2010. Under the Act, the top estate and gift tax rates drop from the current 55% to 50% in 2002. It then drops 1% a year until it reaches 45% in year 2007. In the year 2010 the estate tax is repealed, but the gift tax remains in place with a maximum rate of 35% and an exemption amount of $1 million. When estate and generation-skipping taxes are repealed in the year 2010, a modified-carryover-basis rule will go into effect. At that point, death will create an income tax problem, because the basis of assets received from a decedent will carry over to the beneficiary. The current law allows market value to be used as the beneficiary's basis. For example, if a decedent acquired land in 1985 for $50,000 and died in 2010 when the land had a market value of $500,000, under current rules the beneficiary's basis would be stepped up to $500,000. Under the new law, the beneficiary of the land would use $50,000 as a basis, for income tax purposes. There are two exceptions to this rule that will alleviate some of the problems. * $1.3 million of basis can be added to certain assets. * $3 million of basis can be added to assets transferred to a surviving spouse. To complicate matters further, the state death-tax credit allowed against the federal estate tax will be reduced by 25% in 2002, 50% in 2003, 75% in 2004, and 100% thereafter. This will cause federal estate taxes to increase. Taxpayers will have to do some thoughtful estate planning over the next ten years. Wills and marital and family trusts may have to be amended. Some wealthy taxpayers may require annual estate plans to take advantage of the various changes applicable to each year. At the very least, taxpayers should review their current estate plans in light of the changes that will take place over the next ten years. Retirement Plan Enhancement The new law includes a host of retirement savings incentives and pension plan reforms. These are welcome relief for taxpayers able to take advantage of them, and businesses that must administer the plans. Increased contribution limits and tax-favored savings options should enable many taxpayers to better plan for their retirement. Increased Contribution Limits for IRAs. Starting in 2002, the new law gradually increases the amount a person can contribute each year to a traditional IRA or Roth IRA. The current $2,000 limit will be increased to $3,000 in 2002, $4,000 in 2005, and $5,000 in 2008. These amounts will be adjusted for inflation in $500 increments starting in 2009. The new law also allows an individual age 50 or over to contribute a larger amount of money to his or her IRA. These extra contributions are called catch-up contributions. Such taxpayers can contribute an additional $500 each year starting in 2002, and an additional $1,000 starting in 2006. The chart below illustrates their IRA contribution limits. | |
IRA CONTRIBUTION LIMITS FOR INDIVIDUALS AGE 50 AND OLDER
Year Regular IRA Catch-up Total IRA
Contribution Limit Contribution Contribution Limit
2002 $3,000 $500 $3,500
2003 $3,000 $500 $3,500
2004 $3,000 $500 $3,500
2005 $4,000 $500 $4,500
2006 $4,000 $1,000 $5,000
2007 $4,000 $1,000 $5,000
2008+ $5,000 $1,000 $5,000
| | 401K Plan Enhancement. The Act enhances the value of salary reduction plans such as 401K, 403(b) and 457, by increasing the general contribution limit and allowing individuals over age 50 to make catch-up contributions. The limits are increased from the current $10,500 to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005, and $15,000 in 2006, with cost-of living increases (in $500 multiples) thereafter. Individuals age 50 and over are allowed to make additional annual contributions to these plans. Catch-up contributions are allowed as follows: $1,000 in 2002, $2,000 in 2003, $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006 and thereafter. Defined Contribution and Defined Benefit Plan Changes. Defined contribution plans specify how much will be contributed into a plan. For example, an employer may specify 10% of an employee's salary will be contributed to a retirement trust fund. Presently, the annual addition to a participant's account in a defined contribution plan (e.g. profit sharing or 401K plan) is limited to the lesser of 25% of the employee's compensation or $35,000. Effective in 2002, this will be increased to the lesser of 100% of compensation or $40,000. Most other provisions in the tax code that limit the amount that can be contributed to a retirement account have been increased. Defined benefit plans specify how much an employee will receive when he or she retires. For example, a plan may state that employees will receive 50% of their average salary for the last three working years. It would also specify how many years they would have to work and at what age they would be eligible for retirement. Current law requires that defined benefit plans can take into account no more than $170,000 of an employee's compensation in determining their retirement benefits. This limit is increased to $200,000 beginning in 2002 and then indexed for inflation in $5,000 increments. Also, the maximum annual limit on benefits an individual can receive from a defined benefit plan is increased from the current $140,000 to $160,000. This is effective for 2002 and is indexed for inflation in $5,000 increments. Expanded Rollover Rules. The Act simplifies and liberalizes the rollover rules. It will be much easier to roll over or transfer retirement assets from one plan to another. In the past, taxpayers were frequently required to use IRAs for pension plan transfers. The new law generally permits rollover of assets between 401K plans, profit-sharing plans, money-purchase pension plans, government plans, 403(b) plans and traditional IRAs. For example, under prior law you could rollover a 403(b) plan only to another 403(b) plan. Thanks to the new law, these restrictions are removed. Taxpayers can roll over 403(b) or 401K plan to an IRA or other employee-sponsored retirement plans. Tax Planning Challenge. When President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001, he made tax history. The 10-year, $1.35 trillion tax package represents the most significant change in tax law since the Tax Reform Act of 1986. While the new tax legislation significantly overhauls the tax system, it is by no means tax simplification. As a result, tax planning will be more difficult Many of the provisions of the new legislation are phased in over a number of years, some in 2001 and others stretching out to 2010. Uncertainty is created by the inclusion of a sunset provision, which means Congress must reaffirm the new law's provisions at some later date or the changes will terminate after December 31,2010. CPAs and tax attorneys are studying the Act to gain an understanding of the new legislation's deductions, credits, reform aspects, changes, and the timing of each. Many taxpayers will rely on their advice to make their tax plans and minimize their tax obligation. However, to best utilize tax advisors' services, taxpayers need a general understanding of the changes in tax law so that they know what inquiries to put to these advisors. In light of the gradual reduction in marginal tax rates, taxpayers should be considering the possibility of deferring income to future years. They also should be considering accelerating the recognition of deductions, to offset them against income at higher marginal tax rates. However, they must be aware of how the alternative minimum tax affects their status. Benefits received by reductions in a taxpayer's regular tax liability can be lost to the higher alternative minimum tax. Remember, many more taxpayers will become subject to the alternative minimum tax. Tax planning should take advantage of the modifications to Education IRAs and Qualified Tuition Programs. Those taxpayers who have the financial means should take advantage of the more favorable tax changes in these plans. Taxpayers will have to review their estate plans in light of the many changes made by the new legislation to estate, gift, and generation skipping transfer taxes. Wills may have to be redone, gift plans changed, and family trusts amended. The tax act contains many new provisions to encourage taxpayers to save for retirement Taxpayers with the financial means will be able to save more due to increases in the amounts allowed to be contributed to qualified plans. Lower income workers will be entitled to a tax credit, rather than a tax deduction, for contributions to qualified retirement plans. The Act seems to offer something for every taxpayer. Some taxpayers may benefit more than others due to their financial or specific circumstances. However, some taxpayers may benefit more due to thoughtful tax planning and continual review of their financial circumstances. References (1.) 2001 Tax Legislation, Law, Explanation and Analysis; Economic Growth and Tax Relief Reconciliation Act of 2001, CCH, Inc. 2001. (2.) Biebl, A, R. Ranweila, G. McKeen, and D. Puckett. 2001 Tax Act, AICPA-PDI, 2001. (3.) Stretch, C., and P. Hennessy. Seeds of Change, The 2001 Tax Cut. Deloitte & Touche Tohmatsu, 2001. (4.) Jones, G., and M. Luscombe. "Making Sense of the New Tax Legislation," Journal of Accountancy, September 2001, 22-28. (5.) Jones, G., and G. Yaksich, Jr. "New Tax Law Brings Challenges and Opportunities to Small and Family Business," The Trusted Professional, NYSSCPA, August 2001 Vol. 4, 13. (6.) Laffie, L. "New Tax Act Expands Education IRAs," Journal of Accountancy, August 2001, 75-77. (7.) McGorry M. "Distribution Changes Under the 2001 Economic Growth and Tax Relief Reconciliation Act," Distribution Advisor, Panel Publishers, August 2001, Vol. 1, Issue 3, 1-10. (8.) TIAA/CREF, "New Tax Bill Offers Opportunities for Investors," Participant, August 2001, 16-19. (9.) UBS/Paine Webber, "How the New Tax Law Impacts You," UBS/Paine Webber, 2001. (10.) West, R. "Tax Benefits of Qualified State Tuition Programs," The CPA Journal, June 2001, 27-33. |
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