THE ECONOMIC GROWTH & TAX RELIEF RECONCILIATION ACT OF 2001-THE GOOD, THE BAD AND THE UGLY!

The $1.35 trillion federal tax cut, which is to be phased in over the next 10 years, includes tax-rate reductions, child credit increases, marriage penalty relief, education incentives, estate-tax repeal (actually suspension and much confusion), and retirement plan provisions, among other changes. $875 billion of the tax cut comes in the final five years. There are 85 major provisions, 441 Internal Revenue Code changes with 291 pages of official bill text.

The new law imposes a complicated array of unprecedented back-loaded (i.e. time-delayed) benefits, with varying effective dates that span ten years. Some provisions are retroactive; some start next year; others won’t start until five, or even ten years from now. The following is a summary of the major provisions:


Individual Rate Reductions
The new law introduces a new 10% tax rate. Individual taxpayers will immediately benefit from the new 10% rate in 2001. Rather than incorporating the 10% rate into the 2001 tax rate schedules, the new law directs the Treasury to mail a "rebate" check to most individual taxpayers who filed a return for 2000, providing an immediate tax benefit. (For those who didn’t timely file for 2000 or had no or a small tax liability, an adjustment will be made on the 2001 return.) The "rebate" amounts will be up to $600 for joint filers, up to $500 for heads of households, and up to $300 for single filers and married persons filing separately. Anyone who filed, but was claimed by someone else as a dependent, will not receive a "rebate" check.

The remaining tax rates will also be reduced, starting July 1, 2001. By 2006, when the reduction is completed, the previous rates of 28%, 31%, 36%, and 39.6% will be 25%, 28%, 33%, and 35%, respectively.

So who benefits? Those who remain in the 15 percent bracket will get no more of a benefit than taxpayers only earning $10,000. Those in the top 39.6 percent bracket, however, eventually will receive a 4.6 percent tax cut each year of approximately $7,782.

Itemized Deduction Reduction Repealed
Higher income taxpayers who itemize deductions on their federal tax returns must reduce their
deductions if adjusted gross income (AGI) exceeds a certain inflation-adjusted threshold ($132,950 in 2001; $66,475 for married persons filing separately). The new law gradually repeals the itemized deduction reduction. The otherwise applicable reduction will be reduced by one third for 2006 and 2007, and by two thirds in 2008 and 2009. Effective for tax years beginning after 2009, the itemized deduction reduction will be repealed.

Personal Exemption Phaseout
Under the new law, the otherwise applicable exemption phaseout will be reduced by one third in 2006 and 2007 and by two thirds in 2008 and 2009. After 2009, the personal exemption phaseout will be totally repealed.

Child Tax Credit
Before the new law, eligible taxpayers could claim a $500 tax credit. Under the new law, the child tax credit is increased to $1,000, phased in over 10 years, starting in 2001. Existing adjusted grossed income levels for the credit remain the same ($110,000 married, $55,000 single). The new law allows the child tax credit to be claimed permanently against the alternative minimum tax for tax years starting after 2001.

The phase-in schedule for the child credit is:

Adoption Tax Benefits
Currently, taxpayers may claim a tax credit for qualified adoption expenses of up to $5,000 a child ($6,000 in the case of a special needs child). The credit is phased out ratably for taxpayers with $75,000 to $115,000 of AGI. Effective for years starting after 2001, the maximum credit increases to $10,000 per child for all adoptions, and the phaseout starting point becomes $150,000 of AGI.

Dependent Care Credit
Current law allows a taxpayer to claim a dependent care credit for a portion of qualifying child or dependent care expenses paid for the purpose of allowing the taxpayer to work. The maximum annual credit is currently 30% of up to $2,400 of expenses for one qualifying individual and $4,800 for two or more. The credit percentage is reduced in steps to 20% as AGI increases from $10,000 to over $28,000. Effective for years starting after 2002, the 30% credit percentage increases to 35% and the maximum amount of eligible expenses rises to $3,000 for one qualifying individual and $6,000 for two or more. Plus, the credit percentage "phase-down" to 20% will occur when AGI increases from $15,000 to over $43,000.

In a related provision, beginning in tax years starting after 2001, employers may claim a tax credit equal to 25% of qualified expenses for employer-provided child care and 10% of qualified expenses for employer-provided child care resource and referral services, up to a maximum $150,000 credit per tax year.

Marriage Penalty Relief
A married couple may file a joint tax return and be treated as one taxpayer, so that taxes are paid on the couple’s total taxable income. (While a married couple may file separate returns, this usually results in higher taxes than filing jointly.) A "marriage penalty" exists when the combined tax liability of a married couple filing jointly is greater than the sum of their tax liabilities computed as though they were two unmarried filers. The new law adds several measures to alleviate the marriage penalty, but not until 2005.

The following are the tax savings from the tax rate cut for married couples filing jointly, projected for 2006 and thereafter:

Taxable Income Tax Savings

Standard Deduction Increase
The tax law allows individuals who do not itemize deductions to claim a standard deduction. The new law increases the basic standard deduction for joint filers to twice the basic standard deduction for an unmarried person filing a single return. The increase is phased in over five years, beginning in 2005, and is fully applicable in 2009 and later years.

Expansion of 15% Bracket
The new law increases the size of the 15% regular income-tax bracket for joint filers to twice the size of the corresponding 15% rate bracket for an unmarried person filing a single return. The increase is phased in over four years, starting in 2005.

The new law also makes adjustments to the earned income credit to provide additional marriage penalty relief for lower earners.

Education IRAs
The annual limit on contributions to education IRAs is increased from $500 to $2,000, beginning in 2002. In addition, the definition of qualified education expenses is expanded to include elementary and secondary school expenses. The Hope or Lifetime education credit will now be allowed in the same year as a distribution from an Education IRA.

Qualified Tuition Programs
Distributions from state-sponsored qualified tuition programs will not be taxed beginning in 2002. Distributions from non-state programs will not be taxed after 2003.

Student Loan Interest Deduction
The limit on the number of months during which interest is paid on a qualified education loan is eliminated after 2001. In addition, the income phase-out for this deduction is increased from $50,000 to $65,000 for single filers and from $100,000 to $130,000 for joint filers.

College Tuition Credit
There will be a new deduction for college tuition beginning in 2002. This is a deduction directly against income and available even if a taxpayer does not itemize deductions. For 2002-2003, a single taxpayer with adjusted gross income below $65,000 ($130,000 if married) will be entitled to a $3,000 annual deduction. In 2004 and 2005, the deduction will increase to $4,000. Single taxpayers with adjusted gross income between $65,000 and $80,000 ($130,000 to $160,000 if married) will receive a $2,000 deduction in 2004 and 2005. After 2005, this deduction is set to expire. The deduction can’t be claimed in the same year as a Hope or Lifetime Learning credit is claimed.

IRA Contribution Limits
The current contribution limits for both traditional and Roth IRAs will increase to $3,000 for 2002 to 2004; $4,000 for 2005 to 2007; and $5,000 for 2008 and thereafter. There will be annual adjustments for inflation after 2008.

Taxpayers who are age 50 and above will be permitted to contribute additional amounts to either their traditional or Roth IRAs. They can contribute an additional $500 in 2002-2005; $1,000 in 2006 and thereafter.

401(k) Contribution Limits
The allowable contribution limits will increase from the current $10,500 to $15,000 by 2006. The contribution will increase to $11,000 in 2002 and increase by an additional $1,000 each year thereafter until 2006.

Defined Contribution Plan Limits
Starting in 2002, the limit on contributions to a defined contribution plan will increase to $40,000.

Defined Benefit Plan Limits
Starting in 2002, the limit on benefits under a defined benefit plan will increase to $160,000 from the current $140,000.

SIMPLE Plan Limits
The limit on maximum annual elective deferrals to a SIMPLE plan will increase 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).

Alternative Minimum Tax
Those subject to the AMT will not receive a rate reduction. Rates are still 26 percent for the first $175,000 of AMT income after applying a $45,000 exemption, and at 28 percent for the balance. However, the number of taxpayers subject to the AMT will increase significantly by the time all benefits under this new law are phased in. However, the new law does make the child credit offset against AMT permanent.

Estate Tax Relief
Estate taxes continue through 2009 but with an increasing exemption to $3,500,000 by 2009. In 2010 the estate tax is completely repealed. However, in 2011 the current estate tax and exemption comes back into law unless Congress extends the repeal.

The phaseout of the estate tax will follow a slow timetable:

Year Top Estate Tax Exemption
Rate Amount

To complicate matters further, once the estate tax is fully repealed in 2010, a modified carryover basis 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. There will be some relief in that $1.3 million of basis will be allowed to be added to certain assets; and $3 million of basis will be permitted to assets transferred to a surviving spouse. Not all property is eligible for an increase in basis. Property acquired by a decedent by gift from a non-spouse less than three years before death is excluded (to prevent "gifts" of low basis assets in anticipation of stepped-up bequests). Stock in foreign investments and personal holding companies are also excluded.

Gift Tax
A modified gift tax is retained. 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.

Tax Planning
Tax-free investments/entities
Reduced tax rates make tax-exempt investments less competitive unless their yields are increased. Similarly, the benefits of operating as a tax exempt organization are devalued as the general tax rate decreases.

Deferred compensation
The planning opportunities after the phased-in rate cut will be to postpone 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 will take some of the value off converting wages to incentive stock options and other equity-based compensation.

Family income shifting
As long as a family member is not subject to the "kiddie tax" (under 14 years of age), shifting up to $6,000 in income ( for example, dividend or interest income) to a child or other family member can save 25 percent in taxes even when the new rates are fully phased in (the difference between the 10 percent and 35 percent brackets).

Choice of entity
Personal service corporations are currently taxed at a flat 35 percent rate, while regular corporations are taxed at graduated rates from 15 to 38 percent. With personal income tax rates moving lower than the average corporate rate, more businesses should consider organizing and operating as sole proprietorships, partnerships, and S corporations rather than as C corporations.