last update 12-4-01
2001 Income Tax Act
The TAX RELIEF RECONCILIATION ACT OF 2001
George W Bush has made quite an impact with the passage of major tax
legislation in the first 6 months of his administration. This is the largest
tax measure passed by Congress in the last 10 years that includes cuts in
income tax rates, significant marriage penalty tax relief, doubling of the
child tax credit, expansion of educational tax credits, phase out of the
estate tax and major pension reform, just to mention a few items.
You have read about it in the paper, saw discussions on TV and have
talked about it with friends. You think you know what the new law is
all about. After you read this newsletter, you may realize that the new
law was much bigger than you thought, is more complex than you
thought and, although it has a lot of good points for your tax planning,
it has some things in it that you need to be aware of.
For instance, with all the talk about doing away with the Federal Estate
Tax in the next few years, did you know that the estate tax will be back
and bloom in full force again in the year 2011, just like an old ragweed,
unless Congress does something to keep it down. The "elimination" of
the estate tax is not a real elimination it is only smoke and mirrors that
makes it go away for a short period and then comes back again as strong
as it is now.
I have tried to summarize the major points of the new tax law in a
manner that most people can understand. If you have any detailed
questions, please call me and I will try to provide you with an answer.
Here are the provisions of the new law.
Individual Income Tax Cuts
The centerpiece of the new law is a sizable reduction of the marginal tax
rates for individuals. Most taxpayers come out ahead under these new
rate cuts, which start with the creation of a new 10% rate bracket that
will result in "advance refund" checks being issued to most taxpayers
by October 1. All other individual income tax rates (except the 15%
rate) are also cut for 2001, effectively by 0.5 percent across the board.
Basically, a portion of your income that was taxed at 15 percent will
now be taxed at only 10%. This is true no matter how much your
income is, or how you file your return. If you are single or married, the
first $6,000 of your taxable income will be taxed at 10%.
The rate reduction has no effect on the Social Security or Medicare taxes
that you pay. Those taxes will remain the same at 6.2% and 1.45%
respectively.
Despite initial ambitious plans to have only four rate brackets that would
cap at 33 percent, Congress eventually compromised and, in doing so,
actually added a rate bracket. There will now be six rate brackets for
individuals.
Does all this about rate cuts sound great? Well, don't get too excited.
Most of the rates drop only one percentage point and hold there for
2001-2003, then they drop another percentage point for 2004 and 2005
and then drop another percentage point for 2006 and thereafter. Thus,
the cuts are not big-time nor are they coming very quickly. However,
we should all be appreciative of the little things in life.
Eliminating Itemized Deduct Limitations
In the past, higher income taxpayers lost some of their itemized
deductions and personal exemptions under a phase out plan. That plan
generally kicked it at income levels above $150,000 and resulted in a
"back-door" added tax for those people. The new law provides a
gradual elimination of that phase-out provision but, again, don't plan a
vacation on your tax savings.
The overall limitation on itemized deductions and the personal exemption
phase outs will be reduced by in years 2006-2007, and then by
another in years 2008-2009 and then completely eliminated starting
in year 2010.
Current Year Tax Refund
Whether you make $1 million or $12,000 of income for 2001, you will
get a $300 tax benefit from the new law ($600 if you are married filing
jointly and $500 if you are head of household). This is the refund that
you will be receiving this summer and is really no more than a way for
Congress to make you feel like they gave you something. To get that
$300 refund, you probably had to pay in taxes of $600 to provide the
funds for the administrative costs to send the money back to you.
Alternative Minimum Tax BUMMER
If you are taxed on capital gains, have oil and gas depletion, or other tax
favored benefits, you have probably had to pay a separate or alterative
minimum tax (AMT) in the past. This is a separate tax applied to people
who have special tax breaks to ensure that they pay a certain "minimum"
tax.
In computing the AMT, you re-compute your entire tax return
eliminating all of the tax favored benefits, then apply an exemption of
$45,000. The first $175,000 of income is taxed at 26% and the balance
at 28%. Then the resulting tax is compared to the "regular" tax and you
pay the LARGER tax figure.
For those taxpayers who are subject to the AMT, the new tax law
provides NO benefit at all. Although the computation of the "regular"
tax may show a smaller figure, the AMT computation is not changed so
you will continue to pay the larger AMT tax.
According to government projections, the number of taxpayers subject
to the AMT under its current form will increase six-fold by the time all
benefits under this new tax law are phased in. Meaning?: the new law
will not provide as much relief as has been touted.
Marriage Penalty Tax Relief
The so-called "marriage penalty tax" results from the comparison of the
filing categories of single versus married. Theoretically, two single
people earning the same level of income should be able to get married
and have overall rates for their combined income such that the total taxes
due would be the same as if they were still single. NOT So!
The rate structure has been such that the married couple would pay more
taxes than two single people with the same income. Thus, it has been
properly referred to as the "marriage penalty tax".
The new law will provide some relief in this area, but again not right
now. First, there is no relief in this area until 2005 some 3 years away.
Second, when relief is available, it will be phased in over a four year
period. Again, don't plan your vacation on the tax savings from this
little jewel.
Child-Related Tax Relief
The new law doubles the current child tax credit of $500 to $1,000----
but phased in over a 10 year period. It does begin now in year 2001 at
$600 and creeps up to the full $1,000 in 2010 and later. This credit is
refundable to the extent of 10 percent of the taxpayer's earned income
in excess of $10,000 for calendar years 2001-2004. The percentage is
increased to 15 percent for years 2005 and thereafter. The bill also
provides that the refundable portion of the child credit does not
constitute income and is not treated as resources for purposes of
determining eligibility or the amount or nature of benefits or assistance
under any federal program or any state or local program financed with
federal funds.
Excited about this? Don't be. From a practical standpoint, only parents
of a child now younger than eight years of age will realize the $1,000
for that child when the credit is fully phased in. Assuming a 3.25 %
annual inflation rate, the $1,000 credit will be worth only $747 in
current dollars by the year 2010.
Adoption Credit
We have had a special credit of $5,000 for adoptions of non-special need
children and a credit of $6,000 for special need children. The new law
increases the credit for both categories to a $10,000 credit effective
starting in year 2002. It also doubles the income phase-out range
starting point from $75,000 to $150,000. Yup! You are right. If you
make more than $75,000 now or more than $150,000 after this year, you
will not qualify for the credit.
Dependant Care Tax Credit
The new law increases the dependent care credit rate from 30% to 35%,
increase the amount of eligible employment-related expenses from
$2,400 to $3,000 and increases the beginning point of the phase-out
income to $15,000 of adjusted gross income, starting in 2002.
Estate Tax Relief
Your representatives in Congress have claimed to have repealed the
estate tax. More precisely, however, the new law repeals the estate tax
for only one year namely in year 2010. Due to the wording, the new
law allows the current estate tax rules, rates and exemptions to come
back in full force in year 2011. Thus, under the new law, estate taxes
continue albeit with an increasing exemption from $1 million to $3.5
million.
One advantage of the new estate tax rules is that the current exemption
of $675,000 will jump to $1 million on January 1, 2002. Thereafter it
will steadily climb with reductions in the tax rate until it jumps back at
us in year 2011 as follows:
Tax
Year Rate Exemption
2002 50% $1 million
2003 49% $1 million
2004 48% $1.5 million
2005 47% $1.5 million
2006 46% $2 million
2007 45% $2 million
2008 45% $2 million
2009 45% $3.5 million
2010 repealed n/a
2011 55% $1 million
OUCH!
Modified Carryover Basis
One tax loophole that has helped many people has been the "stepped-up
basis rule". This relates to the tax basis of property received from a
decedent.
Generally, the original cost of property is your "basis" in the property.
When you sell it, the difference between the sales price and this basis
and is normally taxed as capital gains.
The prior law has provided that heirs and the surviving spouse got a
stepped up basis to the fair market value as of the date of death. Thus,
if Pops bought land in 1950 for $1,000 and it is now worth $100,000,
he would have had a gain of $99,000 if he sold it prior to death. After
death, his heirs took the property from his succession with a new basis
of $100,000 as though they had bought it for $100,000. Thus, no
income tax gain until the property goes up higher in value. That rule
also has applied to the wife's portion of the property that she owns with
Pops even though she may not actually inherit any of his share.
The new law changes this rule in year 2010. At that time, death
becomes an income tax problem. The basis of assets received from a
decedent will be the original basis or cost of the decedent with no step-
up in basis to current fair market value.
There is some relief for smaller estates but not for all categories of
property. The estate will be allowed a step-up basis of $1.3 million and
there will be an extra $3 million step-up in basis on property left to a
spouse.
But for most real estate, stock, investments or other assets that remain
in a family for generations, there will be a new need for accurate records
of original costs or basis. Without proof of what the original costs was,
the full sales price of an asset may be subject to taxation.
Currently, there is a tax credit or direct reduction of the Federal tax on
the Federal Estate Tax Return for death taxes paid to a state. From 2002
to 2005, this credit will be phased out. However, the actual death taxes
paid to a state will be allowed as an expense or deduction to the estate
but not as a credit against the tax.
This will have little effect for residents in Louisiana. We are currently
in a phase out period here in which the Louisiana inheritance tax will be
completely eliminated by June of 2004.
Family Owned Business Deduction
Prior law included an estate tax exclusion for individuals owning certain
qualified family-owned business interests. Up to $1.3 million in value
of a closely held business could have been treated to the advantage of the
estate as long as the business continued to be closely held within the
family for the next 10 years.
The new bill repeals this provision for decedents dying after December
31, 2003. Although this provision is lost, the new and higher exemption
amounts should still shelter the business values that needed this section
in the past.
College Tuition Deduction
The new law introduces a package of education-related tax breaks,
including a temporary college-tuition deduction and a more generous
deduction for student loan interest. These are as follows:
There will be a new "above-the-line" deduction for qualified higher
education expenses. For 2002-2003, a taxpayer will be entitled to a
$3,000 deduction which will rise to $4,000 for 2004-2005. As you
might expect, this deduction is not available for singles making more
than $65,000 or a couple making more than $130,000. It is also not
available if the HOPE or Lifetime Learning credit is claimed.
Education Savings Accounts
Distributions from Education Individual Retirement Accounts (now
called Education Savings Accounts) are free from federal taxation if they
are used to pay for qualified education expenses. The new law greatly
expands the prominence that education IRAs will play in future family
savings strategies.
Currently, annual contributions to these accounts are capped at $500.
The new law raises the limit to $2,000. Starting in 2002, contributions
will be allowable not only from individuals but also from corporations,
tax-exempt organizations and other entities. Contributions can be made
until April 15 of the year claimed for the deduction rather than the
December 31 requirement that has been in place.
In the past, the phase-out level for joint filings claiming this deduction
was $150-160,000 but that will be raised to $190-220,000.
In what is one of the most controversial provisions in the new law,
proceeds in education savings accounts are now available to pay for
elementary and secondary school tuition public and private as well as
the costs of higher education. Covered expenses include tutoring,
computer equipment, room and board, uniforms and extended day
program costs.
Enhanced Student Loan Deduction
The new law permits more student loan interest considerably more to be
deducted. Current rules permit taxpayers to deduct up to $2,500 in
student loan interest "above-the-line". The deduction also had been
severely limited by the rule that a taxpayer's adjusted gross income must
fall under a certain threshold and the interest must be attributable to
payments made during the first 60 months in which interest payments are
required. The new law scraps these restrictions. It raises the income
phase-out thresholds for married filers from $60-75,000 to $100-
130,000.
Voluntary payments of interest, such as interest-only payments made
while a loan is in forbearance, have also been made eligible for "above-
the-line" deductions.
Qualified Tuition Plans
The law expands the scope of qualified tuition programs and alters the
tax treatment of distributions. Currently, taxpayers may pre-pay higher
education tuition costs only under state-sponsored qualified tuition
programs. Now, private institutions of post-secondary learning will be
able to sponsor qualified tuition programs as well. Additionally,
distributions from state-sponsored qualified tuition programs will be
excludable from gross income if made after December 31, 2001.
Distributions from non-state programs would be excludable if made after
December 31, 2003.
Employer-Provided Assistance
Under present law, educational expenses paid by an employer for its
employees are generally deductible by the employer. Employer-paid
educational expenses are excludable from the gross income and wages
of an employee if provided under a Code Section 127 educational
assistance plan or if the expenses qualify as a working condition fringe
benefit. An exclusion from the gross income of $5,250 is provided for
annually for employer-provided educational assistance. The exclusion
does not apply to graduate courses beginning after June 30, 1996. The
exclusion for employer-provided educational assistance for
undergraduate courses expires with respect to course beginning after
December 31, 2001.
The new law makes permanent the employer-provided educational
assistance exclusion (up to $5,250 annually), and extends coverage for
both undergraduate and graduate courses.
Retirement Savings and Pension Reform
Pension reform comprises over a third of the size of the new law in
terms of bill text. Retirement savings incentives, including expansion
of IRAs and 401(k) plans, alone are projected to cost $40 billion. For
its proportionate cost as compared to other portions of the Act, this
portion of the new law covers a lot of ground.
The law permits greater contributions to tax-advantaged savings plans,
such as qualified plans (including 401(k)s and IRAs). Here are some of
the more popular changes that have been made to qualified plan and
contribution limits.
The contribution limits for both traditional and Roth IRAs will rise from
the current $2,000 annual cap to $5,000 with it going to $3,000 for
years 2002-2004, $4,000 for years 2005-2007 and $5,000 for 2008 and
thereafter with annual adjustments for inflation after 2008.
Taxpayers who are age 50 and above will be permitted to contribute
"catch-ups" to their IRAs. They can contribute to an IRA an additional
$500 in 2002-2005, $1,000 in 2006 and thereafter. These "catch-up"
payments can either be deductible or made to a Roth IRA, if the base-
line AGI limits are met for regular contributions for the year.
Starting in 2002, the limit on annual additions to a defined contribution
plan will rise to $40,000. The annual limit on benefits under a defined
benefit plan will rise from $140,000 to $160,000.
The limit on salary reduction contributions to 401(k) type plans,
including 403(b) annuities and salary reduction SEPs will rise from
$10,500 to $15,000 by 2006 with an initial rise in 2002 to $11,000 and
additional $1,000 amounts each year until 2006.
Lower income workers will be entitled to a tax credit, instead of just a
tax deduction, for contributions to retirement savings. Joint filers
earning less than $30,000 will be entitled to the maximum 50% credit.
The limit on maximum annual elective deferrals to a SIMPLE plan will
increase to $10,000 by 2005 (scheduled to start at $7,000 in 2002 and
then increase $1,000 each year until the $10,000 limit is reached in
2005).
The law includes numerous measures to increase protection of plan
participants, including shortening of vesting schedules and enhancing
portability of pension assets; and permitting workers to become vested
and eligible for employer matching contributions in three rather than five
years.
Retirement Account Rollovers
Starting in 2002, it will be easier to roll over the balance from a
qualified retirement plan to another qualified plan. Currently, you
cannot make a tax-free rollover of your IRA balances into a qualified
plan such as a 401(k). Under the new law, you will be allowed to roll
over amounts from your IRA into any eligible retirement plan, whether
it is another IRA or a plan sponsored by your employer. However, your
employer's plan is not required to accept these rollovers.
Also beginning in 2002, you will be able to roll over your "after-tax"
contributions to your employer's defined contribution plan or to an IRA.
The "after-tax" contributions are amounts you paid tax on, but which
were contributed to a retirement plan sponsored by your employer.
The additional flexibility for rollovers is based on the idea of portability.
As you move from one employer to another, this flexibility provides a
greater opportunity to preserve your retirement savings.
Credit for New Retirement Plans
Many small employers are reluctant to provide retirement plans for their
employees due to the costs associated with setting up and administering
the plans. Such costs include fees to change the payroll system, set up
an investment vehicle and obtain advice about the plan.
Under the new law, small employers with no more than 100 employees
will receive a tax credit for some of the costs of setting up a new
retirement plan, effective for costs paid after December 31, 2001. The
credit equals 50% of the start-up costs to create or maintain a new
employee retirement plan. The credit is limited to $500 in any tax year
and it may be claimed for costs in each of the 3 years beginning with the
tax year in which the plan becomes effective.
======================== WARNING =======================
AND DISCLAIMER
This information is provided for the reader's benefit in
becoming familiar with the legal matters discussed. Your
particular facts may be different from the points above.
You should not rely on the above data without consulting a
attorney to discuss the specific facts of your case
and the law of your state.
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If you live in Louisiana and want to talk about your situation, please
call me at:
Marvin E. Owen
Attorney-CPA
3036 Brakley Drive
Baton Rouge, La 70816
ph 225-292-0099
toll-free 1-888-292-0116
e-mail marvin@meocpa.com
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