Tax Relief:
Tax Relief Reconciliation Act of 2001

In Brief:

The centerpiece of the Tax Relief Reconciliation Act of 2001, which is scheduled to be signed sometime after the Memorial Day congressional recess, is a $958 billion consolidation and reduction of the marginal tax rates of individuals, relief from the marriage penalty, doubling of the current child tax credit to $1,000 over the next 10 years, a package of education related tax breaks (including a temporary college tuition deduction), and reforms to retirement savings and pension laws.
 

INCOME TAX RATE CUTS

As noted, the centerpiece of the new law is a $958 billion consolidation and reduction of the marginal tax rates for individuals. Most taxpayers come out ahead under these rate cuts, which start with the creation of a new 10 percent rate bracket that will result in "advance refund" checks being issued to most taxpayers by October 1, 2001. Treasury Secretary Paul O'Neill stated that he hopes the government will be able to accelerate the delivery of these tax refunds checks, getting them into taxpayers' hands before September. Taxpayers should expect refund checks in the following amounts: $600 for joint filers, $300 for single filers, and $500 for heads of households. The refunds are based on each taxpayer's 2000 tax return; trusts and estates, nonresident aliens and taxpayers claimed as dependents are not eligible for an advance refund. All individual income tax rates above 15% are also cut for 2001, but are not subject to advance refunds.

The new law provides six rate brackets for individuals. The rate reduction schedule is being implemented as follows:
 

*Effective July 1, 2001.

In addition to the reduction in the marginal tax rates, higher-bracket taxpayers will receive a back-door tax cut through the gradual elimination of the overall limitation on itemized deductions and the phase-out for personal exemptions. The overall limitation on itemized deductions will be reduced by1/3 in 2006-2007, by 2/3 in 2008-2009, and completely eliminated starting in 2010. The personal exemption phase out similarly will be reduced by 1/3 in 2006-2007, by 2/3 in 2008-2009, and completely eliminated starting in 2010.

Although each taxpayer will receive a refund check of at least $300, starting in July 2001 some taxpayers will receive more than others: those who remain in the 15 percent bracket will get no more of a benefit than taxpayers only earning $10,000 in income, while those in the top 39.6 percent bracket eventually will receive a 4.6 percent tax cut each year on all their marginal income (no matter how high it rises because of inflation). In addition to the $600 bonus for joint filers, taxpayers at the top bracket will additionally receive approximately $7,782 resulting from part of their income being taxed at 25 percent instead of 28 percent, and part of their income being taxed at the 28 and 33 percent rates instead of the 31 and 36 percent.

Figuring out winners and losers by running through the numbers based on the new tax rate schedules is the easy part. Far more complicated is the task of assessing the importance that lower rates will have on future tax strategies. A listing of areas for consideration include:
 

Capital gains transactions: Legislators continue efforts to bring net gains from the sale of long-term capital assets into the tax-cut juggernaut. 

 

Family income shifting techniques: Use of the lower tax brackets has been a mainstay of family income shifting. As long as the family member is not subject to the "kiddie tax" (under 14 years of age), shifting up to $6,000 in income to a child or other family member can save 25 percent in taxes even when the new rates are fully phased in.

 

Deferred compensation: The potential planning opportunities in the aftermath of a phased-in rate cut will be based on postponing the recognition of income until a lower-rate year, i.e., to a year during the phase-in of the new rates or to a post-2006 year. On the other hand, lower rates on ordinary income will take some of the value off converting wages to incentive stock options and other equity-based remuneration.

 

Retirement planning. Although reduced tax rates will leave taxpayers with more money to put in IRAs or 401(k) plans, they will also make saving for retirement on a tax-deferred basis less of a priority. One clear exception: lower tax rates should make Roth IRAs more attractive especially if you believe tax rates can only go up in the future when you will be withdrawing IRA assets.

 

Tax-free investments/entities. A rate cut makes tax-exempt investments less competitive unless they are able to match the change with higher yields. Similarly, the benefits of operating as a tax-exempt organization are devalued as the general tax rate decreases.

Marriage Penalty Relief

Marriage penalty relief finally is a reality, although a "penalty" will still exist in part. The relief, which will not start until 2005, will take two forms. It will include providing joint filers with a standard deduction that is twice the amount of standard deduction provided to single filers, which will be phased in over a four year period starting in 2005 and ending in 2008. It will also expand the high-end of the income level falling under the 15 percent tax rate bracket to an amount equal to twice that of single taxpayers over a 2006-2008 period.

The phase-in schedule for the increase of the standard deduction for married couples is:
 

174% of that for singles in 2005,

180% in 2006,

187% in 2007,

190% in 2008,

200% in 2009 and later.
 

The phase-in schedule for expansion of the 15 percent rate is:
 

180% of that for singles in 2005,

187% in 2006,

193% in 2007,

200% in 2008 and later
 

Statistically, most taxpayers above the new 25 percent tax bracket will not be taking the standard deduction and therefore will continue to be subject to the current marriage penalty. On the other hand, expansion of the 15 percent rate will not impact those who currently are in the 15 percent bracket, that is single taxpayers with taxable income of under $27,050 and married taxpayers with taxable income below the $45,200 level.
 

Child Related Tax Relief

Child Tax Credit: The new law doubles the current child tax credit to $1,000, phased in over 10 years. The increase is effective for tax years beginning after December 31, 2000. In addition, the new law allows the credit to be claimed against the alternative minimum tax permanently and repeals the AMT offset of refundable credits. The credit is made refundable to the extent of 10 percent of the taxpayer's earned income in excess of $10,000 for 2001-2004, increasing to 15 percent after 2004.

The increase would be gradual and would not be fully implemented until 2010. Retroactive application would increase the credit, currently at $500, to $600, for 2001. Existing adjusted gross income levels for the child tax credit ($110,000 married, $55,000 single) are left unchanged. The phase-in schedule for the child credit is:

2001-2004 - $600

2005-2008 - $700

2009 - $800

2010 and later - $1,000 

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.
 

Adoption Credit: The new law increases the credit for adoptions to $10,000 for both special needs adoptions (currently at $6,000) and non-special needs adoptions (currently at $5,000). It also doubles the income phase-out range starting point from $75,000 to $150,000. These new limits will be effective starting in 2002.
 

Dependent Care Tax Credit: The new law increases the dependent care credit rate from 30 to 35 percent, increases the amount of eligible employment-related expenses from $2,400 to $3,000 (from $4,800 to $6,000 for more than one qualifying individual), and increases the beginning point of phase-out income to $15,000 of adjusted gross income, starting in 2003.
 

Estate Tax Relief

Despite reports to the contrary, the estate tax has not been repealed. The new law repeals the estate tax for one year only - 2010. Due to budgetary restrictions, the new law allows the current estate tax rules, rates and exemptions to come back in force in 2011. Thus under the new law the estate tax continues, albeit with an increasing exemption from $1 million to $3.5 million through 2009, until 2010 when it is repealed only for that year.

The generation-skipping transfer tax would be pegged to the highest estate tax rate during the ten-year repeal period.

Once estate taxes are fully repealed in 2010, a modified carryover basis rule immediately goes into effect. At that time, death becomes an income tax problem. 

The basis of assets received from a decedent will carry over from the decedent, rather than be stepped up to fair market value at the date-of-death or alternate valuation date as is now the law. Two exceptions to this general rule exist:
 

• $1.3 million of basis will be allowed to be added to certain assets; and 

 
• $3 million of basis will be permitted to be added to assets transferred to a surviving spouse. 

 

To prevent significant use of gifts to transfer income-laden property from higher to lower rate taxpayers, the new law retains a modified gift tax. Starting in 2010, gifts in excess of a lifetime $1 million exemption would be subject to a gift tax equal to the top individual income tax rate at that time.

The state death tax credit allowed against estate tax will be reduced by 25% in 2002, 50% in 2003, 7% in 2004, and will be completely repealed thereafter, to be replaced by only a deduction for death taxes. Florida currently levies an estate tax equal to the state death tax credit allowed by federal law. There has been no indication how the Florida legislature will deal with the state estate tax as a result of the changes in federal law.
 

Education Tax Cuts

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.

College Tuition Deduction: An above-the-line deduction for qualified higher education expenses is introduced in the new law. For 2002-2003, a single taxpayer with adjusted gross income below $65,000 ($130,000 if married) will be entitled to an above-the-line tuition deduction of $3,000 each year. In 2004 and 2005, the deduction will increase to $4,000 for singles with incomes below $65,000 and married filing jointly with incomes below $130,000. Single taxpayers with incomes up to $80,000 and joint filers with incomes up to $160,000 are permitted a maximum deduction of $2,000 in 2004 and 2005. After 2005, this deduction is scheduled to lapse. This deduction cannot be claimed in the same year as a HOPE or Lifetime Learning credit for the same student.

Education Savings Accounts: Distributions from education individual retirement accounts (now dubbed "education savings accounts") are free from federal taxation if they are used to pay for qualified education expenses. The new legislation greatly expands the prominence that education IRAs will play in future family savings strategies. Currently, annual contributions to education savings accounts are capped at $500. The new law raises the limit to $2,000. The new law also exempts special needs beneficiaries from the prohibition against contributions being made after a beneficiary turns 18. Starting in 2002, contributions will be allowable not only from individuals but also from corporations, tax-exempt organizations and other entities. Contributions counted toward any tax year will be permissible until April 15 of the following year, rather than being cut off on December 31.

The ability to contribute to an education savings account has also been broadened. The current contribution phase-out range for joint filers of $150,000 - $160,000 jumps to double that of single filers ($190,000 - $220,000). And in 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.

The new law permits more student loan interest 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 (to $55,000-$65,000 from $40,000-$50,000 for singles, and to $100,000-$130,000 from $60,000-$75,000 for joint filers). It repeals completely both the annual dollar limit on the amount of the deduction and the 60-month limit. Voluntary payments, such as interest-only payments made while a loan is in forbearance, have also been made eligible for above-the-line deductibility under the new law.

The scope of qualified tuition programs has been expanded and the tax treatment of distributions has been altered. 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.

Among a handful of other education-related provisions are changes that allow:
 

• HOPE and Lifetime Learning tax credits to be claimed in the same year as education IRA distributions, as long as the IRA distribution is not used to pay for the same costs used to claim the education credit, and

 
• Penalty-free contributions to education IRAs and qualified state tuition programs to be made in the same year. 

 

Retirement Savings and Pension Reform

Over 1/3 of the new law deals with reforms to retirement savings and pension reform. The new law permits greater contributions to tax-advantaged savings plans, such as qualified plans (including 401(k)s and IRAs). Highlights of the new law include:
 

• Raising of the contribution limits for both traditional and Roth IRAs from the current $2,000 annual cap to $5,000 ($3,000 for 2002- 2004; $4,000 for 2005-2007; and $5,000 for 2008 and thereafter ) with annual adjustments for inflation after 2008.

 
• Permitting taxpayers age 50 and above to contribute "catchups" to their IRAs. They can contribute to an IRA an additional $500 in 2002 - 2005; $1,000 in 2006 and all years thereafter. These "catchup" 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, raising the limit on annual additions to a defined contribution plan to $40,000. 

 
• Starting in 2002, raising the annual limit on benefits under a defined benefit plan from $140,000 to $160,000.

 
• Raising the limit on salary reduction contributions to IRC §401(k)-type plans [including 403(b) annuities and salary reduction SEPs] from $10,500 to $15,000 by 2006 (scheduled to rise to $11,000 in 2002, and increase by an additional $1,000 each year until 2006).

 
• Entitling lower income workers 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.

 
• Increasing the limit on maximum annual elective deferrals to a SIMPLE plan 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 limit on compensation taken into account under a qualified plan rises to $200,000 (to be increased for inflation in $5,000 increments).

 
• Providing 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.

 
• Raising the limit on an employer's deduction for contributions to certain types of defined contribution plans to 25% of compensation; modernizing and streamlining pension laws to encourage small businesses to offer pension plans; providing tax credits for small business start-up costs and matching contributions; and modifying "top-heavy" rules.

Conclusion

The new law significantly changes the current system of taxation, primarily for those taxpayers in the higher tax brackets. Because of the retention and increase in tax brackets, taxpayers should continue their tax planning strategies to take advantage of lower tax brackets.