This page 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.

Before discussing these provisions, however, we want to explain why you may receive an "advance refund" check later this year.

Advance Refund Checks Due Later This Year
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). The Treasury Department will determine who is entitled to an "advance refund" - and the amount - based on each taxpayer’s 2000 income tax return information.

Phased-in Individual Income Tax Rate Cuts
Besides creating the new 10% bracket, Congress mandated rate reductions in other tax brackets, beginning after June 30, 2001, except for the 15% bracket. 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%.

Tax Benefits Relating to Children
The new law covers four broad areas relating to children. Here are the highlights.

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).

Employer-Provided Child Care Facilities. The legislation creates a new credit of up to $150,000 per year for employers who provide employees with child care facilities or child care resource and referral services. The new credit applies in taxable years beginning after December 31, 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.

Marriage Penalty Relief
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.

A more targeted "marriage penalty"-related provision, which also takes effect in 2002, increases the income phase-out range to permit more joint filers to qualify for "Education IRAs," discussed below.

Education Provisions
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" provisions. 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 $2000 per beneficiary (from $500) and
• Increases the phase-out range for joint filers to twice the amount for singles, thus making the phase-out range $190,000 to $220,000 of "modified adjusted gross income."

Qualified Tuition Plans. Also effective in 2002, the legislation contains several provisions liberalizing the rules governing these plans, including a provision that 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. Tax-free distributions from private plans, however, will not be available until 2004. Also, tuition credits or certificates will be available from private plans, but such plans will not be able to receive contributions to a savings account.

Employer Provided Educational Assistance. The legislation makes the exclusion, which was scheduled to expire at the end of this year, permanent, and extends the exclusion to graduate level courses beginning after December 31, 2001.

Student Loan Interest Deduction. Beginning in 2002, the new law:

• 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.

Retirement Savings Provisions
The new law largely incorporates another piece of legislation, called the "Comprehensive Retirement Security and Pension Reform Act of 2001." Here are some highlights.

Increases in IRA Contribution Limits. 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 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.

Increased Benefit and Contribution Limits for Qualified Retirement Plans. Effective for years beginning after 2001, the legislation:

• 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.

Plan Loans to Owners. The new law should benefit the owners of many closely held businesses by generally eliminating the special rules relating to plan loans to S corporation shareholders, partners, and sole proprietors, thus permitting such loans without automatically triggering a violation of the "prohibited transaction" rules.

Death Tax Repeal
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.

1. 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";
2. Complete repeal will not occur until 2010;
3. 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.

"Sunset" in 2010?
One final aspect of the legislation merits comment. 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.

Bruce A Rukkila, CPA, PC