Tax Briefing: 2001 Legislation
RELIEF BILL HAS SOMETHING FOR EVERYBODY,
BUT NOT TOO MUCH, NOT VERY SOON
(RIVERWOODS, ILL., May 26, 2001) – With passage of the Economic Growth &Tax Relief Reconciliation Act of 2001, President Bush has won enactment of the major points in the tax program he has advocated since he was a candidate, according to CCH INCORPORATED (CCH), a leading provider of tax law information and software. (For complete coverage of the tax bill, including taxpayer scenarios and separate pension and estate tax coverage, visit: www.cch.com/taxbill.) A general rate reduction, lessening of the “marriage penalty,” a doubling of the child tax credit and an elimination of the estate tax are at the core of the new tax law. But, there is much in the bill that Bush never advocated, and the end result may be much more modest and more delayed than the president and his supporters hoped for.
“Relief is broader than Bush proposed – including a wide range of education tax breaks and enhanced opportunities for tax-advantaged retirement savings – but it isn’t as deep,” said CCH Principal Tax Analyst Mark Luscombe, JD, CPA.
To garner bipartisan support, the total size of the package has been trimmed from an estimated $1.6 trillion to $1.3 trillion, while at the same time a number of provisions have been added. The result is that a number of presidential priorities have been diluted or deferred. The top tax rate will remain higher than the 33- percent rate the president sought in his proposal, income limitations on the ability to take the child tax credit will not be raised and “marriage penalty” relief will not begin to kick in until 2005.
At the same time, taxpayers who might have gained little from the original Bush plan will benefit from the bill. Low-income taxpayers will be more likely to gain from the child tax credit and, if they are married, from the Earned Income Tax Credit. Middle-income families will be eligible (though briefly) to take a tax deduction for college tuition costs. People saving for retirement will find significant new incentives in the bill that were never part of Bush’s agenda.
“As might be expected, compromises have to be made to get the bill through Congress,” said Luscombe. “This means that many people will benefit less than they thought they would, while others will benefit more.”
The bill lowers ordinary income tax rates for the first time since 1986. Taxpayers can look forward to parting with a smaller percentage of their taxable income in the years ahead, with an initial rate reduction scheduled to kick in this year (part of it retroactive to January 1) and further decreases in 2004 and 2006.
All taxpayers will reap the benefit of a new 10-percent bracket that will apply to the first $12,000 of taxable income for those filing jointly, $10,000 for heads of households and $6,000 for single filers. In 2008, the $12,000 limit will increase to $14,000 and the $6,000 limit will increase to $7,000.
The new bracket is effective retroactive to the beginning of this year, and it will take the form of a credit. The bill provides that taxpayers who filed their 2000 tax returns on time will receive the credit in the form of checks – up to $300 for singles, $500 for heads of households and $600 for joint filers – which the Treasury Department is supposed to send out before October 1.
Above the new lowest bracket, the 15-percent bracket stays in place, but the 28-percent, 31-percent and 36-percent brackets will step down one percentage point beginning July 1 of this year. This will produce effective rates for 2001 of 27.5, 30.5 and 35.5 percent. These rates will step down 1 percent again in 2004 and one last percentage point in 2006, when they will level off at 25 percent, 28 percent and 33 percent. The current top rate of 39.6 percent will decrease, along with the other rates, to 38.6 percent on July 1 (making an effective 2001 rate of 39.1), 37.6 percent in 2004 and 35 percent in 2006.
“These reductions seem fairly modest, but they can change the way people plan their financial affairs,” Luscombe noted. “For example, someone now in the 28-percent bracket whose top rate falls to 25 percent will have less of an incentive to ride out a risky investment for the sake of a 20-percent long-term capital gain rate.”
Married Couples Get Relief
Married couples filing jointly will see additional reductions in their tax bills through an increase in their standard deductions and a widening of the 15-percent tax bracket. Currently, both of these are pegged at 167 percent of the amounts for single filers. In 2001, for example, the standard deduction for singles is $4,550; for joint filers it is $7,600. The 15-percent bracket covers the first $27,050 for singles; for joint filers it covers the first $45,200.
This can create a “marriage penalty,” since two single people earning equal amounts pay more tax when they marry than they did when they were single. Their standard deduction is not twice the amount each was entitled to before they tied the knot, and whether they itemize or not, their combined incomes frequently are taxed at a top rate higher than the one they paid as individuals.
To address the penalty, the bill provides that four years from now, the percentage differential between single and joint filers for both the standard deduction and the top end of the 15-percent bracket will start to increase until they are double those for single filers.
The standard deduction differential will increase to 174 percent in 2005, 184 percent in 2006, 187 percent in 2007, 190 percent in 2008 and 200 percent in 2009 and thereafter.
The top end of the 15-percent bracket for joint filers will increase to 180 percent of that for single filers in 2005, to 187 percent in 2006, 193 percent in 2007 and 200 percent in 2008.
If these changes were in effect now, joint filers would see an increase in their standard deduction of $1,500 to $9,100, while their 15-percent bracket would extend an additional $8,900 to $54,100.
Married couples will also get a break with the Earned Income Tax Credit, or EITC. Currently, the joint income of a married couple is treated no differently than the income of a single person for purposes of calculating the credit. In 2002, the bill increases the level at which the EITC begins to “phase out” for joint filers by $1,000 and increases the top of the phase-out range by $1,000 as well. In 2005, the range will be raised $2,000 from its current levels and in 2008, the range will be set at $3,000 above current levels and then indexed for inflation. The end result should be less of an EITC penalty for low-income wage earners who get married.
“What’s significant about marriage-penalty relief in this bill, unlike Bush’s original proposal, is that it ends with the standard deduction and the 15-percent bracket,” Luscombe observed. “Bush wanted relief for all couples with dual wage-earners, regardless of income. He’s getting a bill that offers relief at the low end, and to all married couples, whether there are two wage-earners or one.”
Although the bill lowers the top tax bracket only 4.6 percentage points, to 35 percent – rather than the 33-percent top rate sought by the president – upper-income taxpayers will benefit from additional forms of relief down the road.
Beginning with the 2006 tax year, the provisions of the current law that restrict the value of itemized deductions and personal exemptions will be reduced by one-third, and they will be reduced by two-thirds in 2008. Beginning with 2010, the restrictions will no longer exist. This is one of the few areas in which the new law actually simplifies the Internal Revenue Code.
Finally, the bite of the alternative minimum tax, or AMT, which tends to affect higher-income taxpayers more than others, is being somewhat softened – at least temporarily. In calculating potential alternative minimum tax liability, taxpayers can take advantage of generous “AMT exemption amounts” – $45,000 for joint filers, $22,500 for married people filing separately and $33,750 for all others. Beginning with the present tax year, the bill increases the exemption amounts by $4,000 for joint filers and $2,000 for everyone else. But, this relief ceases to apply for tax years beginning after December 31, 2004.
“This provision gives some relief from the AMT to the increasing numbers of people who will otherwise be subject to it, and will preserve for some people the benefits of rate reductions which would otherwise be nullified through the action of the AMT,” Luscombe said. “But the relief is small and temporary. Serious action on the AMT will have to wait until another bill.”
Child Credit to Double
The bill contains several new or expanded tax benefits relating to children. The child tax credit, one of the most widely available credits introduced in recent years, is due to double under the bill, from $500 to $1,000 over the next 10 years, beginning with a $100 increase to $600, effective for the 2001 tax year. Further $100 hikes are scheduled for 2005, taking the credit to $700, and 2009, when it will reach $800. The final increase, to $1,000, is scheduled for 2010.
But whereas Bush’s original plan sought to make people with higher incomes eligible for the credit, by raising income phase-out limits, the bill enhances the benefits of the credit at the other end of the income scale.
Up until now, the credit has not been refundable except for families with three or more children. This has meant that a family with one or two children that owed no tax received no further benefit from credit. Beginning with this tax year, the new law allows a family to claim a refundable credit, to the extent of 10 percent of their earned income in excess of $10,000 or the credit amount, whichever is less. For example, if a family had one child and earned income of $13,000 in 2001, they could get a refund of $300 as a result of the child credit, even though they owed no tax to begin with. The 10-percent figure will rise to 15 percent in 2005 and the $10,000 figure will be indexed for inflation beginning in 2002.
One measure in the bill that will benefit all those eligible for the credit is to preserve it from the operations of the AMT.
More Help With Kids
People who pay for child care – including employers who provide day care or referral services to their employees – and those who adopt will find more tax help in the bill.
The bill increases the maximum amount of eligible dependent care expenses for the dependent care credit from $2,400 to $3,000 if there is one qualifying dependent and from $4,800 to $6,000 if there are two or more qualifying dependents. The percentage that can be claimed increases from 30 percent of qualifying expenses to 35 percent. In addition, the income level at which credit amounts begin to “phase down” rises from $10,000 to $15,000, so that more taxpayers will receive the full benefit of the credit.
The bill also helps encourage employers to provide day care for their employee’s children. Beginning next year, businesses will be eligible for a tax credit of 25 percent of actual child care expenses they provide and 10 percent of the cost of child care resource and referral services they offer, with a cap of $150,000 per tax year.
Finally, the tax credit for adoption expenses will be expanded and made a permanent part of the tax code under the bill. The maximum credit will rise next year to $10,000 for all adoptions, whether they are of special needs children or not. Beginning in 2003, the credit will be available for special needs adoptions in the year they are finalized whether the taxpayer has eligible expenses in that year or not.
The beginning point for phasing-out the credit will double, from $75,000 to $150,000, starting next year. Similar increases will apply to adoption assistance received through an employer’s plan.
New and Bigger Breaks for Education
Education initiatives in the new law include a significant expansion of education IRAs, permanent extension of the exclusion for employer-provided educational assistance, liberalization of rules for deducting student loan interest and a deduction for higher education expenses.
Although the president was in favor of increasing the size and scope of education IRAs, his education initiatives were not part of his original $1.6 trillion tax plan. Including them – as well as a number of retirement savings provisions – in the bill, while at the same time shrinking the 10-year price tag of the legislation to $1.3 trillion, is responsible for some of the lower levels and delayed implementation of other types of relief in the bill.
The size of permissible contributions to education IRAs is being quadrupled, from $500 to $2,000, while the permissible uses of the accounts is being broadened to encompass paying tuition, room and board, books and computer expenses for public, private or parochial primary and secondary education. Contributions to an education IRA will be permitted even if contributions to a state tuition program are made in the same year on behalf of the same beneficiary.
A distribution from an education IRA can be taken in the same year that the Hope or lifetime learning credits are taken, as long as they are used to cover different expenses. Contributions for any given tax year can be made up until the filing date (usually the following April 15) for that year, as is the case with other IRAs.
To eliminate a “marriage penalty” written into prior law, the bill also increases the income phaseouts for joint filers contributing to educational IRAs to begin at $190,000 and end at $220,000 – twice the amounts as for single filers.
Education IRAs were introduced in 1997 tax legislation, but they have not proved popular thus far.
“With a $500 annual limit, educational IRAs were not seen as especially attractive savings vehicle by parents facing the prospect of college tuition costs alone running to tens of thousands of dollars a year,” Luscombe observed. “The higher annual contribution amounts and broadening the scope to include primary and secondary expenses make these accounts a more realistic way of pre-funding education expenses – particularly for high school since you have a longer time to invest than you do for elementary schools.”
The bill also enhances the attractiveness of other plans that are designed to pre-fund college tuition. Currently, such programs are offered by state governments (although their portfolios may be overseen by investment companies) and while they offer tax-free buildup within accounts, investment earnings are taxable when they are withdrawn.
The bill authorizes individual colleges and universities to set up the tuition credit or certificate form of such plans (but not the savings account form), and allows participants to exclude all withdrawals of their own contributions and of investment earnings from income as long as the withdrawals are used for qualified purposes.
Employer-Provided Tuition Help
The bill also makes the exclusion of employer-supplied educational assistance a permanent part of the tax code and widens this benefit to encompass graduate education as well as undergraduate courses.
Employees can receive up to $5,200 a year from their employers to meet tuition and certain other educational expenses without having to declare the amounts as income or have any taxes withheld on the amounts. Employers can deduct the amounts on their returns, and they are not liable for employment taxes on the payments.
The provision has been a popular one, but for many years it has led an on-again, off-again existence, frequently expiring at the end of a year only to be re-enacted retroactively the next one.
“Employers will appreciate being able to offer a program to their employees knowing that they won’t have to be prepared to start it, stop it and modify it every year,” Luscombe said.
A Choice of Benefits
The legislation also adds a new – and temporary – way to cope with higher education expenses: an above-the-line deduction that will be available for tax years beginning in 2002 through 2005. For 2002 and 2003, the maximum deduction would be $3,000, and it would be available only to taxpayers with adjusted gross incomes of less than $65,000 for single filers, $130,000 for joint filers. For 2004 and 2005, the maximum deduction would rise to $4,000 for taxpayers under those income limits, while people with incomes above those limits, but under $80,000 for single filers or $160,000 for joint filers could deduct up to $2,000.
“People would have to choose between using this approach and taking the existing Hope and Lifetime Learning Credits,” Luscombe commented. “This could be the more beneficial avenue, but those eligible will have to figure their taxes twice to determine that.”
The legislation also liberalizes the above-the-line deduction for interest paid on educational loans. The deduction for student loan interest is still limited to $2,500 per year, but beginning next year the bill does away with an earlier limitation that permitted the deduction only for the first 60 months of student loan interest payments. The phase-out ranges for the deduction are increased, as well – from $40,000 to $55,000 for single taxpayers and $60,000 to $75,000 for joint filers, to $50,000 to $65,000 for singles, and $100,000 to $130,000 for joint filers.
The legislation also makes certain government scholarships tax-free and expands tax-exempt financing of public school construction.
Many Costs Deferred
In addition to the education and child-related breaks that weren’t a part of Bush’s original plan, the bill packs in a bevy of retirement-related tax measures.
“These are basically proposals that have been knocking around Congress for a long time, with significant support, waiting to be attached to a bill that both houses would pass and the president would sign,” Luscombe said.
But finding room for additional items has meant deferring the implementation of costly proposals – such as marriage penalty relief – that were higher on the president’s original agenda.
“Delaying the implementation of provisions lowers their cost within the 10-year period that has to be scrutinized under congressional budget rules,” Luscombe noted. “But this means that the full costs of many measures won’t be reckoned until many years from now.
“And when it comes to reckoning with any of this tax bill, we have to remember that under current rules, the bill’s provisions, if left unchanged by
Congress, will sunset in 2011, reverting to the current law,” he added.
About CCH INCORPORATED
CCH INCORPORATED, headquartered in Riverwoods, Ill., was founded in 1913 and has served four generations of business professionals and their clients. The company produces more than 700 electronic and print products for the tax, legal, securities, insurance, human resources, health care and small business markets. CCH is a wholly owned subsidiary of Wolters Kluwer North America. The CCH web site can be accessed at www.cch.com. The CCH Federal and State Tax group web site can be accessed at http://tax.cch.com.
Editor’s Note: Additional press releases and related information on other provisions of the tax bill are available at www.cch.com/taxbill.
For members of the press, complimentary copies of CCH’s new tax books including 2001 Tax Legislation: Law, Explanation and Analysis, 2001 Tax Legislation: Highlights, Conference Committee Report, Estate Planning Strategies After Estate Tax Repeal: Insights and Analysis, and Estate Planning Under the New Law: What You Need to Know are available by contacting Leslie Bonacum at 847-267-7153 or at [email protected].
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