Some of the news stories about the Economic Growth and Tax Relief Reconciliation Act of 2001,
("2001 Tax Act" or "the Act") have described it as the largest tax cut in the past 20 years. Many tax reductions are, in fact, contained in the Act, but they are delivered gradually, or "phased-in" over a period of years. The purpose of this article is to describe some of the changes in the Act, and highlight planning opportunities for reducing individual income taxes.
Individual income tax savings come in the form of tax rate reductions, increases in tax credits, exclusions from income, and educational incentives. The Act also offers opportunities to save more for retirement, college, and for estate tax savings, as discussed in earlier versions of The Lane Report. See September 2001, August 2001, and July 2001 Lane Reports, respectively.
1. Reduced Tax Rates
Income tax rate reductions for 2001, are currently effective and will be reflected in refund checks mailed directly to taxpayers. Refunds will not exceed tax liability for the year 2000, so those who did not owe income tax last year will not receive a refund check. These refunds are an advance payment on the creation of a new 10% tax rate as the lowest tax rate beginning in 2001.
In addition to establishing a new 10% income tax rate, the Act prescribes a reduction in income tax rates to occur gradually over the next six years. All taxpayers are taxed at rates based upon taxable income. Since 1983 there have been five tax rates for individuals; 15%, 28%, 31%, 36% and 39.6%.
Rates are reduced to 10%, 15%, 27.5%, 31.5%, 35.5%, and 39.1% in 2001. By the year 2006 the rates will be 10%, 15%, 25%, 28%, 33%, and 35%. Income tax rates for estates and trusts are also reduced.
2. Itemized Deductions
Limits on itemized deductions also were repealed, beginning in the year 2006. Taxpayers who itemize deductions must now reduce deductions (other than medical expenses, investment interest and casualty, theft or wagering losses) if Adjusted Gross Income ("AGI") exceeds $132,950 for married joint filers ($66,475 for married taxpayers filing separately). The total of otherwise allowable deductions must be reduced by 3% of the amount by which AGI exceeds $132,950. The repeal of this reduction begins in the year 2006, and is phased-in over a 5 year period. For 2006 and 2007 the amount that otherwise would be non-deductible is itself reduced by one-third (meaning one-third more of that amount will be deductible). For 2008 and 2009 the amount otherwise non-deductible is reduced by two-thirds. For tax years after 2009 the limitation on itemized deductions is repealed.
For example, assume a married couple with adjusted gross income for 2001 of $182,950 has $10,000 in itemized deductions. Their income exceeds the $132,950 threshold by $50,000, so $1,500 ($50,000 x 3%) is not deductible. Assuming no change in income or deductions, and no inflationary adjustments, in 2006 the amount not deductible will decrease to $1,000 ($10,000 - $1,500 x 66.6%). In the year 2008 only $500 would be phased-in ($10,000 - $1,500 x 33.3%).
3. Personal Exemptions
The personal exemption phase-out for taxpayers with income above certain levels is also to be repealed, starting in the year 2006. A personal exemption amount of $2,900 is generally permitted for a single taxpayer, and married joint filers are entitled to two personal exemptions, or $5,800. This exemption is currently reduced by 2% for each $2,500 by which the taxpayer's AGI exceeds an "applicable threshold amount." Once the taxpayer's AGI reaches an upper limit, the exemption is fully phased-out. The threshold amount and upper limits for 2001 are as follows:
Filing Status Threshold/Upper Limit
Married Filing Jointly $99,725/ $160,975
Heads of Households $166,200/ $288,700
Married Filing Jointly $199,450 / $321,950
Like the limit on itemized deductions, the Act gradually repeals these limits, beginning in 2006 until it is completely repealed for tax years beginning after 2009. For 2006 and 2007 the taxpayer's exemption which must be reduced is itself reduced by 1/3. For 2008 and 2009 the reduction is reduced by 2/3.
4. Alternative Minimum Tax
Individuals may not get the benefit of the Act, if they are subject to the Alternative Minimum Tax, or AMT. The AMT is a flat rate tax of 26% or 28% designed to prevent taxpayers from avoiding taxes through excessive deductions. Historically the levels at which it is imposed have not been indexed for inflation, so many middle income individual taxpayers are impacted. An individual who was subject to AMT last year and continues to have the same AMT adjustment items will not benefit from any tax rate reductions otherwise available under the Act.
However, the Act does provide some relief for taxpayers subject to AMT. Taxpayers with significant income tax deductions for items such as accelerated depreciation, passive activity losses,
and state and local tax deductions may be subject to an AMT. Currently, up to $45,000 of AMTI (alternative minimum taxable income) for married taxpayers filing jointly is currently exempt from AMT. This exemption amount is increased under the Act to $49,000 for tax years 2001, 2002, 2003 and 2004. The exemption amount for single taxpayers is increased from $33,750 to $35,750. The increase ceases to apply in 2005 and thereafter.
Individuals who have paid the AMT in the past, or who have large families, incentive stock options, capital gains, significant state and local tax liabilities or other tax preference items are advised to calculate whether AMT tax would be due for this year. If calculations show that AMT may be owed this year, the best strategy to use is to defer payment of any deductible expenses such as property taxes until next year, and accelerate income, if possible. Where AMT does not look like it will be a problem, the standard advice still applies: claim all possible deductions this year and delay income until next year.
5. Benefits for Families; Child Tax Credit, Dependent Care Credit and Adoption Credit
The 2001 Tax Act provides several benefits for families, most of which do not take effect until next year or later. A child tax credit of $500 is currently available for each "qualifying child" of an eligible taxpayer. The new Act raises the credit amount to $600 for 2001 through 2004, $700 through 2008, $800 in 2009 and $1,000 in the year 2010.
The level of eligible expenses for which a dependent care credit is available is increased from $2,400 to $3,000 for one child or dependent and from $4,800 to $8,000 for two or more children or dependents effective in 2003. Up to 35% of eligible expenses will be the maximum credit and income limits for phasing-out the credit will also be relaxed.
A related provision also will allow employers to claim a tax credit of 25% of "qualified child care expenses" for employer-provided child care, and 10% of qualified expenses for child care resource and referral services, up to a maximum of $150,000 per year, again effective in the year 2003. Qualified child care expenses eligible for the credit include acquisition, construction, rehabilitation or expansion of property used as part of a qualified child care facility, which may not be part of a principal residence of the taxpayer or an employee of the taxpayer. Also, services may not be provided selectively to business owners or Highly Compensated Employees. Special rules will apply for recapture of the credit if the facility ceases to operate within 10 years of starting up, and to reduce the cost basis of the property.
The adoption credit for individuals who pay qualified adoption expenses in connection with adoption of an eligible child has been increased to $10,000 per child, whether or not the child has special needs, effective for 2003. Currently the adoption credit may not exceed $5,000 per child on a cumulative basis, and $6,000 for special needs children. Children with special needs are specifically defined in Internal Revenue Code Section 23 and include certain children with medical conditions such as physical, mental or emotional handicaps.
The credit may be claimed in the year adoption is finalized, even if no adoption expenses have yet been incurred. Taxpayers with modified adjusted gross income exceeding $150,000 will experience a limitation on the credit, and the credit will disappear entirely when income exceeds $190,000. The phase-out range under prior law was $75,000 to $115,000, so the credit is now more widely available. Modified adjusted gross income calculated for this purpose is the taxpayer's adjusted gross income without applying the foreign earned income exclusion or the foreign housing credit. The adoption credit will now also be allowed to offset AMT, on a permanent basis.
Employer provided adoption assistance continues to be excluded from income under similar income limitations, and those ceilings are also raised from $5,000 per child and $6,000 for special needs children to $10,000 for special needs and other adopted children effective for years beginning after 2002.
The special needs foreign adoption credit is scheduled to expire December 31, 2001, and this has not been repealed under the new Act. No credit will be allowed with respect to adoption of a special needs child if the adoption is not finalized by the end of this year. Adoption credits may be used to offset regular and AMT liability, and will affect calculation of the child tax credit and the foreign tax credit.
6. Education Incentives
The Act provides more help to finance education in several ways. For this year a contribution of up to $500 may be made to an Education IRA, without paying a 6% excise tax on excess contributions, subject to income limitations. Single filers with AGI in excess of $95,000 will have a reduced contribution limit, which will be eroded entirely once their income reaches $110,000. For married joint filers the phase-out currently begins at the AGI level of $150,000. Next year the contribution limit is quadrupled to $2,000, and married joint filers with income up to $190,000 are eligible for the full contribution. Amounts accumulating in these IRAs should dramatically increase with the new higher limits. Families may consider rolling over unused portions of an IRA for an older child, to the benefit of younger children to accumulate more IRA funds for them. If the income limits pose a problem, contributions need not be made by the parent; a child, relative, friend, corporation, trust or other entity is also entitled to this deduction. The Act also now allows tax-free distributions to be used for elementary or secondary school.
Those planning now to pay for college will be able to take tax-free withdrawals from an Education IRA or 529 Plan and claim a HOPE Credit ( up to $1,500) or a lifetime learning credit (up to $1,000) if income limitations are met. Credits may not be taken for expenses paid with tax-free earnings. The Act also allows a new above the line deduction for tuition, room and board, of up to $3,000 per year with certain AGI phase-out beginning in 2002. Also, effective next year, coordination rules apply with the HOPE Credit, lifetime learning credit, Education IRAs and Section 529 plans to prevent any double benefit. Credits are generally more valuable than deductions, but both options should be calculated to make a final determination of which is more valuable in your individual circumstances.
Finally, many paying off student loans will be able to deduct more of the interest, since the phase-out for deducting up to $2,500 of student loan interest is raised from between $40,000 and $55,000 of AGI for single taxpayers ($60,000 and $75,000 for married filing joint) to $50,000 and $65,000 in 2002 ($100,000 and $130,000 for married filing joint), and the deduction may be taken over the term of the loan, not just the first sixty months.
The 2001 Tax Act was promoted as a huge tax cut. It was not promoted as tax simplification. The Act does provide significant tax reductions, however as the above illustrates, much of the savings are projected for future years and the calculations are complex.
Further, the political climate changes very quickly. The tragic events of September 11, 2001 have changed the political climate quite dramatically. Taxpayers may never see the post-dated tax savings of the 2001 Act because they may be amended before becoming effective, as a result of the Federal government's financing economic and humanitarian relief as well as the war on terrorism.
The Lane Report is a publication of The Law Offices of Marc J. Lane, a Professional Corporation. We attempt to highlight and discuss areas of general interest that may result in planning opportunities. Nothing contained in The Lane Report should be construed as legal advice or a legal opinion. Consultation with a professional is recommended before implementing any of the ideas discussed herein. Copyright, 2003 by The Law Offices of Marc J. Lane, A Professional Corporation. Reproduction, in whole or in part, is forbidden without prior written permission.