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TAX RELIEF RECONCILIATION ACT OF 2001 SPECIAL REPORT   INTRODUCTION Touted with much fanfare as bold and sweeping - with something for nearly every taxpayer - the Tax Relief Reconciliation Act of 2001 has been hailed as the single largest tax cut in 20 year. Unfortunately, this nearly $1.35 trillion tax cut package is, in fact, a decidedly mixed stew of positives, negative, and uncertainties that is bound to incite controversy in the months and years ahead. On the positive side, small rebate checks are headed for the pockets of millions of taxpayers and there are modest to generous incentives for education and pension planning that many should look into. On the negative side, the Act spans 20 years and features a number of backloaded provision that are literally years away from delivering any real benefits. For example, the estate tax does not get fully repealed until 2010 - and then only for one year! An ominous provision planted in the Act means that every change in the Act could disappear on December 31, 2010 and revert to current condition. This would mean reinstating the estate tax; rolling back pension benefits; and a dramatic increase in rates. As designed, the Act is left open to tinkering by a later administration. In brief, the Tax Act of 2001 makes it more critical than ever to regularly revisit your planning. The following applies for tax years beginning after December 31, 2001, unless otherwise indicated. CHANGES FOR INDIVIDUALS The Act decreases individual tax rates and liberalizes certain credits and deductions, which phase in over a lengthy period. Marginal Rate Reductions - The Heart of the Act The lion's share of the tax cuts in the Act - nearly $900 billion - occurs in this broad- based provision. In general, rate reductions are phased in over six years with a reduction of 1 percent every two years as follows: Tax Year 28% Rate Reduced To 31% Rate Reduced To 36% Rate Reduced To 39.6% Rate Reduced To 2001 27.5% 30.5% 35.5% 39.1% 2002-2003 27% 30% 35% 38.6% 2004-2005 26% 29% 34% 37.6% 2006 and later 25% 28% 33% 35% New Lower Bracket Beginning in 2001, a new 10 percent tax bracket is carved out of the current 15 percent bracket. It applies to the first $6,000 of taxable income for singles, $10,000 for heads of household, and $12,000 for married filing jointly. This translates to a maximum savings of $300 for singles, $500 for heads of household, and $600 for married filing jointly. Cash Back, Right Now For 2001, the Department of the Treasury will soon issue rebate checks in lieu of the new 10% rate for this year. These checks will be sent our ding the next four months to all taxpayers who filed their 2000 income tax return on time. Taxpayers who filed late or on an extension will receive their rebate later in the fall. Tax Planning Ideas Those who expect to pay regular tax - as distinguished from the AMT - should consider: continuing to pay their estimated taxes based on 2000 tax liability deferring income to later years, where possible, to maximize tax savings accelerating deduction and stepping up the timetable for planned charitable contributions to within the next two years AMT to Cause Headaches in High Income Tax States The Alternative Minimum Tax (AMT) is a tax calculation separate from the calculation of a taxpayer's regular income tax liability. Alternative Minimum Taxable Income (AMTI) is calculated by adding back certain deductions and making other adjustments to a taxpayer's taxable income. Two of the more significant add-backs are state and local income taxes and real estate taxes. The AMT is calculated by taking 26 percent of the first $175,000 of AMTI - $87,500 for married filing separately - and 28 percent of the remaining AMTI. To the extent that his tax exceeds the regular tax calculation, the AMT is applicable. Taxpayers are entitled to an exemption amount when calculating AMTI. For tax years 2001 to 2004 only, this exemption amount will increase by $4,000 for married filing jointly and by $2,000 for all other filers. The new law's changes to the AMT do not provide meaningful relief from the AMT. With the reduction of the regular tax rates, the effect will be that many more taxpayers will pay AMT. For them, the reductions in the regular tax will have little or no benefit. Taxpayers in the high income tax states - such as those in the Northeast and California - are particularly likely to pay AMT. AMT Planning Ideas For taxpayers subject to the AMT in 2001, normal planning techniques five a result opposite to the one intended. AMT taxpayers should consider: paying the 4th quarter estimated state income taxes in January 2002 instead of December 2001 paying real estate taxes in early 2002 instead of late 2001 accelerating income since it may be subject to a tax rate of 28 percent instead of the higher regular tax rate of 9.1 percent. Higher Child Credit The $500 maximum credit per child increases as follows: 2001-2004 $600 2009 $ 800 2005-2008 $700 2010 $1,000 This credit is partially refundable to certain low-income taxpayers. It is phased out by $50 for every $1,000 of income above a threshold of $110,000 for married filing jointly and $75,000 for singles. Adoption Credit Doubles Beginning in 2002, the tax credit allowed for qualified adoption expenses is increased to $10,000 for both special needs and nonspecial needs adoptions. This is up from $6,000 and $5,000 respectively. Qualified adoption expenses are reasonable and necessary expenses paid or incurred for adoption fees, court costs, attorney's fees, and other direct costs related to the adoption of an eligible child under age 18. The child cannot be the child of the taxpayer's spouse or from a surrogate parenting arrangement. The adoption credit is phased out for adjusted gross income (AGI) between $150,000 and $190,000. The new law also increases the income exclusion for employer-provided adoption assistance to $10,000. This is up from the current $6,000 for special needs children and $5,000 for non-special needs children. This exclusion is phased out for those with AGI between $150,000 and $190,000 Dependent Care Credit Increase Effective for 2003, the dependent care expenses eligible for the credit increase from $2,400 to $3,000 - and from $4,800 to $6,000, if you have more than one qualifying child. The credit rate also increases form 30 percent to 35 percent with a phase down of 20% for taxpayers with AGI above $43,000. New Childcare Credit for the Employer Starting in 2002, employers will be allowed an entirely new childcare credit up to a maximum of $150,000 per tax year. The credit will be equal to 25 percent of qualified childcare expenses and 10 percent of the cost for contracting childcare resource and referral services for employees. Qualified childcare expenses are those paid or incurred to: acquire, construct, or expand property used as a part of the employer's qualified childcare facility compensate and train employees of the facility contract with a qualified childcare facility for the benefit of employees CHANGES IN THE DISTANT FUTURE Personal Exemption Limitation Phase Out Currently, the personal exemption of $2,900 per person is reduced by 2 percent for every $2,500 of AGI that exceeds certain threshold amounts. For 2001, the thresholds are $132,950 for singles; $199,450 for married couples filing jointly; and $166,200 for head of household. The personal exemption limitation will be gradually repealed beginning in 2006 and completely repealed for year 2010. Limitation on Itemized Deductions Repealed At present, the itemized deduction of higher income taxpayers are reduced based on their AGI. For 2001, the itemized deductions are reduced by 3 percent of the AGI in excess of $132, 950. This limitation will be repealed over a five-year period from 2006 through 2010. Marriage Penalty Relief - Later not Sooner Marriage penalty relief will not take effect until 2006, and will be phased in over five years. The standard deduction amount for joint filers will increase to double that for single filers by 2010. Additional relief will be provided in the form of an expansion of the 15 percent bracket for married couples to double that of the bracket for singles by 2010. EDUCATION TAX INCENTIVES INCREASE Education IRA The Act introduces a number of beneficial provision that: increase the annual contribution amount form $500 to $2,000 and extend the due date for contributions to the succeeding April 15 allow tax free accumulations of both income and distributions for educational purposes. allow the taxpayer to claim available education credits at the same time that withdrawals are made for an Education IRA. raise the phase out income range for joint filers to now start at $190,000 and end at $220,000. expand the definition of education expenses to include elementary and secondary school expenses as well as computers and software used for educational purposes Prepaid Tuition Programs - 529 Plans Amounts distributed from these plans to pay qualified expenses are now excluded from gross income. Employer-Provided Educational Assistance Employer-sponsored education plans - provide in a nondiscriminatory manner - can be excluded for up to $5,250 of the employee's AGI. Further, education expenses now include graduate work. Student Loan Interest The Act increases the income phase out ranges for eligibility for the student loan interest deduction form $50,000 to $65,000 for single taxpayers and to double that amount for joint filers. These income phase out ranges are adjusted annually for inflation after 2002. Also, the 60-month limit on interest paid on qualified loans is repealed. Deduction for Higher Education Expenses Briefly - for 2002 through 2005 - taxpayers are allowed an above-the-line deduction for higher education expenses of as much as $4,000. This deduction is phased out beginning at income levels above $65,000 for singles and double that amount for married couples filing jointly. Also, you cannot take the deduction if you claim available tax credit in the same year. EMPLOYER-SPONSORED RETIREMENT PLANS The Act, in general, encourages retirement savings by increasing deductible contributions for all individuals with some added incentives to those age 50 and over. With these changes, all individuals and business owners should reevaluate their retirement plans. Increase in Retirement Benefits For years beginning on or after January 1, 2002, the amount of covered compensation that can be taken into account for retirement benefits increases from the current $170,000 to $200,000. This amount will be indexed for inflation in $5.000 increments. For a defined benefit plan, the annual pension is increased from $140,000 to $160,000. Employers will be able to increase their deductible funding to provide pension benefits. For profit sharing plans - or stock bonus plans - the annual contribution is increased from 15 percent to 25 percent. The maximum deductible contribution is increased for all defined contribution plans (e.g., profit sharing and money purchase plans) from the current $35,000 to $40,000. For 401(k) plans, 403(b) annuities, and salary reduction SEPs the maximum annual election deferral will increase to $11,000 for 2002. This will increase annually in $1,000 increments to reach $15,000 in 2006. There will then be annual adjustments for inflation in $500 increments. For SIMPLE plans, the maximum annual elective deferrals will increase to $7,000 for 2002. In 2003 and thereafter, the plan deferral limit is increased by $1,000 per year until the limit reaches $10,000 in 2005. After 2005, the $10,000 annual limit is adjusted annually for inflation in $500 increments. For tax-exempt organization plans, the dollar limit on elective deferrals increases to $11,000 for 2002. This will increase annually in $1,000 increments to reach $15,000 in 2006. There will then be annual inflation adjustments in $500 increments. Faster Vesting of Employer Matching Contributions Employer matching contributions now have an accelerated vesting schedule of either: after three years of service of 20 percent per year beginning in the second year of service and ending with 100 percent after six years of service. Employers who want to minimize cost should analyze their workforce turnover rate and experience to determine which vesting schedule to choose. Big Plus for 50 Plus An entirely new concept in tax law can be a boon to those age 50 and older. The law increases the elective deferral to 401(k) plans, section 403(b) annuities, SEP plans, and section 457 plans. This allows additional elective contributions of $1,000 annually - increasing to a maximum of $5,000 for 2006. The elective contribution for a SIMPLE plan is $500 for 2002, increasing by $500 annually to a maximum of $2,500 in 2006. For 2007 and beyond, the $5,000 and $2,500 are adjusted for inflation in $500 increments. These catch-up contributions are excluded from any other contribution limits and applicable nondiscrimination rules. An employer may make matching contributions on the catch-up amount subject to normal applicable rules. These increased elective deferral contribution limits are a tangible expression of the administration's goal to increase retirement savings. Hardship Distributions - A Mixed Bag All hardship distributions to employees form any qualified plan are ineligible for rollover treatment. On the positive side, the employee will now have to wait only six months instead of one year before resuming contributions to the plan. Miscellaneous Employee elective deferrals will be excluded from employer contribution deduction limits. Some of the restrictive rules for top-heavy plans have been eased. The law disallowing plan loans to business owners - sole proprietors, 10 percent partners, 5 percent shareholders of S corps - is eliminated. The IRS fee for certain retirement plan determination letters is eliminated. Small qualifying businesses may now take an income tax credit of 50 Percent of the first $1,000 of expenses relating to the set-up and administration of a new qualified defined benefit plan. You may not deduct expenses used in related to the credit elsewhere. Low income taxpayers between 18 and 60 get an income tax credit equal to a percentage of their contributions to qualified plans. The maximum credit allowed is 50 percent of a $2,000 contribution for tax years 2001 through 2007. ESTATE TAX REPEAL - REAL OR IMAGINARY? The estate tax and the generation skipping tax (GST) will disappear on January 1, 2010 - for only one year! Unless Congress votes to extend the repeal, as of January 1, 2011 the current estate, gift, and generation skipping transfer tax regime will be reinstated. Congressional budgetary constraints will make a permanent repeal a source of heated debate. Because of this uncertainty, estate plans will have to be reviewed and modified in order to provide the flexibility essential to accommodate various possibilities. Estate Tax and GST - Rates go Down and Exemptions Rise Between 2002 and 2009, the maximum estate tax rate will decrease from 55 percent to 45 percent. The state tax exemption increases from $675,000 to $1,000,000 in 2002 and rises to $3,500,000 in 2009. The same decrease in rates and increase in exemption applies for the GST. Then, in 2010, both exemptions are schedules for a one-year repeal (see Chart). Year Top Estate and GST Tax Rate Estate and GST Exemption Amount 2001 55% $675,000 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 Greater Gift Tax Opportunists in 2002 Unlike the estate tax and GST, the gift tax is never repealed. Between 2002 and 2009, the maximum gift tax rate decreases form 55 percent to 45 percent. The gift tax exemption will increase from $675,000 to $1,000,000 in 2002 and - unlike the estate and GST exemption - will remain at that level. Starting in 2010, gifts in excess of the $1,000,000 exemption will be subject to a gift tax equal to the top individual income tax rate at that time. This is currently schedule to be 35 percent. The increase in the exemption to $1,000,000 means you will have an opportunity to make significant gifts next year without incurring a gift tax. State Death Tax Credit Repealed Current law provides for a credit against the federal estate tax for state death taxes paid. The maximum credit permitted is 16 percent of the taxable estate. Most states impose a "soak up" tax equal to the federal credit. This means that, under current law, for an estate in the top 55 percent bracket, only 39 percent of the estate tax is actually paid to the IRS while the remaining 16 percent is paid to the state. Beginning in 2002, the credit starts to phase out, with a total repeal in 2005. The federal credit will be replaced with a deduction for state death taxes actually paid. As a result, states that formerly imposed a soak up tax may decide to impose an estate or inheritance tax to make up for the lost revenue. Since a state death tax cut can have a considerable impact on your estate plan, you'll need to closely monitor developments in your resident state and any other states where you own property. Goodbye, Step-Up in Basis Currently, heirs inheriting property receive that property with a cost basis equal to its fair market value on the decedent's date of death. Any appreciation in the property's value during the decedent's lifetime escapes income taxation. As a result, the heirs receive what is termed an income tax free "step-up" in the property's cost basis. In 2010, the step-up rule gets repealed along with the estate tax. It is replaced with a carryover basis rule. Under the new rule, heirs will receive a basis equal to the lesser of the decedent's basis or fair market value of the assets at the time of death. However, there is some relief. Every estate will be entitled to a basis increase of $1,300,000 to most assets. Further, an additional $3,000,000 of basis can be added to most assets transferred to a surviving spouse. This provision creates a record-keeping nightmare. You'll have to keep track of the costs - including improvements - of all you assets. This includes real estate, stocks, bonds, artwork, jewelry, and antiques. The list goes on and on. To prepare for the change, start maintaining the appropriate records immediately. Adding an exasperating note, the carryover basis rules are also scheduled to expire in 2011 - after one year of life! Unless Congress acts, today's rules will then be reinstated. IRAs - RULES LOOSEN, CONTRIBUTIONS RISE Maximum IRA Contribution Limits Rise The maximum annual contribution for IRAs increases from $2,000 to $3,000 for 2002 through 2004; $4,000 for 2005 through 2007; and $5,000 for 2008. After 2008, the contribution limit will be adjusted annually for inflation in $500 increment. Catch-up provisions for individuals age 50 and over allow additional contributions of $500 for 2002 through 2005 and $1,000 for 2006 and thereafter. Separate Accounts Deemed IRAs If an employer permits voluntary employee contributions to a separate account as part of its qualified retirement plan, this account can be deemed an IRA. These contributions will be treated as wither part of a traditional or Roth IRA. This is effective for plan years beginning after December 31, 2002. New Roth 401(k) Elective deferrals to 401(k) and 403(b) plans can now be treated as Roth IRA-type contributions. These contributions are included in the employee's gross income for the year. Effective in 2005, this rule required the plan administrator to track these funds in a separate account. Eased Rollover Rules Eligible rollover distributions from pension plans, 403(b) annuities, and section 457 plans now can be rolled over to any of these plans. In additional, IRA distributions can be rolled over to these plans. The IRS now has the authority to waive the rule requiring that rollovers be made within 60 days of a distribution. This provision will save taxpayers from the calamity of having an otherwise qualifying rollover disqualified for failure to meet the 60-days rule. In the past, taxpayers were penalized even if they made an effort in good conscience and failed to make the rollover in 60 days due to events beyond their reasonable control. When an employee ceases employment, the plan may distribute the employee's accrued benefit of $5,00 or less without the individual's consent. Before making a distribution that is eligible for a rollover, a plan administrator must inform the participant in writing of the ability to have the distribution rolled over directly to an IRA or to the qualified plan. A direct rollover now becomes the default option for involuntary cash withdrawals exceeding $1,000 and that are eligible rollover distributions form qualified retirement plans. Unless the participant elects otherwise, the distribution would automatically roll over to a designated IRA. SUMMARY The Tax Relief Reconciliation Act of 2001 may appear to be deceptively simple. One would initially assume that most of the tax benefits will "just happen" without taking any alternative steps. After all, individual tax rates will be lower based ona predictable schedule; the child credit will get progressively larger; saving for retirement will be made a bit easier through more liberal IRA and 401K plan rules; and no estate tax will be due-no matter how rich you get-after December 31, 2009. But should taxpayers assume that they can just sit back and let "nature take its course?" In truth, the new law raises many new opportunities, pitfalls….and complications. One cannot afford to overlook them.