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Special Tax Report - 2001

The repeal of the estate tax - sort of.

After months of publicity, President Bush has signed a new tax bill which, among other things, repeals the estate tax - for the year 2010. No, that’s not a misprint. The estate tax has been repealed for the year 2010. After that, due to the drafting of the bill, the law will expire. Unless a future administration implements a bill to the contrary, the repeal ends after one year, and the "sunset" clause causes the law to revert to the current law on Jan. 1, 2011.
Prior to the new bill, the estate tax exemption was $675,000, scheduled to increase to $1,000,000. The new law reduces the top tax rate from 55% to 45% over the next 8 years, and modifies the exemption as follows:

Year Exemption
2001 $ 675,000
2002-2003 $1,000,000
2004-2005 $1,500,000
2006-2008 $2,000,000
2009 $3,500,000
2010 No Estate Tax
2011 $1,000,000

Confused? It gets better. For over 20 years the estate and gift tax system has been a single tax system. That, too, is changing. The final version of the new law does not eliminate the gift tax. Like the estate tax exemption, the gift tax exemption will rise to $1,000,000 beginning in 2002. However, unlike the estate tax, the gift tax exemption will not continue to increase, and will not be eliminated. Additionally, the $10,000 per person annual exclusion for purposes of gift tax remains in place.

This split between the estate and gift taxes is further complicated by the capital gains tax, the tax paid on the gain of an asset. The gain is generally the difference between the final sale price and the basis of the asset. The basis is usually the original price paid (with exceptions). Thus, if you buy a share of stock for $10 and sell it for $25, your gain (or capital gain) is $15 ($25-$10=$15). That gain is taxed at a rate of 10-28%, depending on your tax bracket and the length of time that you held the share. In most cases, the rate for capital gains on assets held for more than one year is 20%.

Under both the old and new law, if you receive an asset as a gift from a person during his or her lifetime, the donor's basis is carried over to you. Thus, if the donor paid $10 for a share of stock, your basis is $10. When you sell that share for $30, you have a taxable gain of $20, which is the same result as if the person who gave it to you had sold the share.

Under the old estate tax law, if you receive the same asset as an inheritance as opposed to a gift, your basis is stepped-up to the asset price on the person's date of death. So, if you sell the asset at the date of death price, you'll recognize no gain for capital gains tax purposes.

The new law largely eliminates the step-up in basis for assets inherited in or after 2010. Each estate will receive a total step-up benefit (i.e. exemption) of $1.3 million; property passing to a surviving spouse will receive an additional $3 million exemption. Assets that pass outside of the exemption will not receive a step-up in basis and will be subject to capital gains tax. This means that many families that would not have paid estate tax under the old law could face significant capital gains tax liability after 2009.

Additionally, be on the lookout for changes in states like New Jersey that have a state estate tax system based on the federal estate tax. These state's budgets may face severe shortfalls with the new cuts. Pennsylvania will not be affected unless the legislature moves to eliminate the Pennsylvania Inheritance Tax; the Commonwealth’s inheritance tax is not tied to the federal estate tax.

Plop... Plop... Fizz... Fizz ... Income Tax Relief It Is?

Also much-heralded in the new tax package is income tax relief for taxpayers. Realistically, many taxpayers may not even notice the difference: the overall reductions take various forms consisting of phased in credits and gradual reductions of tax brackets.

The most publicized piece of the tax bill is the lower tax rates. The income tax rates will change as follows:

Old Rate New Rate
15% 15%
28% 25%
31% 28%
36% 33%
39.6% 35%

In addition, a new 10% tax bracket is created retroactive to January 1, 2001, on the first $6,000 (single) and $12,000 (married) of income. Capital gains rates were not affected.
With respect to the “marriage penalty”, the standard deductions for married couples will rise in phases over 7 years. The standard deduction for married filers will be equal to twice the deduction for that of single filers beginning in 2008. The child tax credit will double from $500 to $1,000 by 2010; in 2001, the credit will rise to $600.
While the President did not reduce the top tax bracket to 33% as planned, he still handed these taxpayers a substantial break. For singles who earn more than $132,950 annually, and joint filers who earn $199,450, the limit on itemized deductions is reduced by a 1/3 in 2006, by 2/3 in 2008, and is eliminated in 2010. The reduction applies to most deductions but does not include medical expenses, investment interest expenses, non-business casualty and theft losses, and gambling losses.

Some taxpayers won’t feel the effect of the new tax law because of the AMT (alternative minimum tax). The AMT was created in the 1980s; it is a separate method of calculating tax liability by reducing deductions taken by taxpayers. The idea was to prevent the super-wealthy from escaping taxation by taking advantage of artificially large deductions. However, the AMT has not been adjusted to consider inflation, and middle class taxpayers are finding themselves subject to the tax. Analysts estimate that nearly one million taxpayers will be subject to the AMT in 2001. You might be affected if you take large itemized deductions; live in a state, such as New York, with high income taxes; or exercise stock options.

Only those taxpayers reporting at least $500,000 in adjusted gross income will receive any real benefit from the reduction in deduction limits. Despite calls to reform the AMT, Congress did not address many of those issues. The amount exempted from the AMT increased, but, like the estate tax bill, the relief only lasts for a limited time.
So what do these changes mean for you this year? To many it means a refund. Taxpayers who filed on time for the year 2000 may receive refund checks. Checks will be issued beginning in July, based on the last two digits of a taxpayer’s Social Security number. Checks issued to joint filers will be based on the Social Security number of the taxpayer listed first on the return.

Higher Learning... Not Higher Lending!

Concerned with the increasing amounts of debt that students and their families are taking on for college and graduate school - and boy can we relate - Congress added and improved tax breaks for education expenses.

Contribution limits to education IRAs have been increased from $500 to $2000 for tax years beginning after December 31, 2001. Additionally, after that date, education IRAs may be used to fund elementary and secondary school expenses; currently, distributions from education IRAs may be used only for qualified higher education expenses. Expenses may include tuition, fees, academic tutoring, books, supplies, room and board, and computer equipment.
The new law also allows deductions for up to $3,000 of college tuition and expenses paid during the school year for 2002 and 2003. The deduction increases to $4,000 for 2004 and 2005. Either the student or the parent can claim the deduction (if the student is a dependent). The deduction is not available to single taxpayers whose AGI exceeds $65,000 or married taxpayers who report more than $130,000.

Section 529 plans, which were reported on in a previous edition of this newsletter, are also changing. The new law authorizes prepaid tuition programs maintained by private education institutions beginning in 2002; previously only public institutions qualified. Additionally, distributions from state tuition programs and private plans are excluded from income to the extent that distributions are used for qualified expenses; this makes the programs as attractive as education IRAs.

And great news for college grads: while the deduction for student loan interest remains limited to $2,500 a year, the 60-month limit and the restriction that voluntary interest payments aren't deductible have been repealed. Income eligibility for the student loan interest deduction will increase to $65,000 from $50,000 for single taxpayers and to $130,000 from $100,000 for married taxpayers beginning in 2002.

Polishing Up Your Golden Years

Finally, the new law includes sweeping changes to qualified retirement plans and IRAs.
The new law increases the maximum contribution levels for retirement funds. The ceiling for IRA contributions will rise from $2,000 to $5,000 over a period of 7 years. In addition, the phase-out for taxpayers who are participants in employer-sponsored retirement plans will almost double within the same time period.
Contribution limits for IRAs will be increased as follows:

Year Amount
2002-2004 $3,500
2005 $4,500
2006-2007 $5,000
2008 + $6,000

Contribution limits to 401(k) plans, 403(b) annuities, SEP, SIMPLE and 457 plans have also been increased.
“Deemed IRAs” within employer-sponsor retirement plans have also been established. Beginning in 2003, qualified retirement plans may allow employees to make voluntary contributions that meet the criteria of a traditional or Roth IRA. The account will be deemed to be an IRA for tax purposes but will not be subject to the regular retirement plan rules.

Defined contribution and defined benefits plans have also affected by the new law. The percentage limit on annual additions for defined contribution plans has been raised to 100% of compensation (from 25%); the dollar limit has been increased to $40,000 (from $35,000) for plans beginning after 2001. For defined benefit plans, the new law increases the annual benefit limit to $160,000 from $140,000.

Congress has also created a new Roth plan. The new law gives employees the option of contributing elective deferrals to a 401(k) or a 403(b) plans on an after-tax basis, referred to as “Roth contributions.” Contributions are not deductible but qualified distributions are tax free, similar to a Roth IRA.

The new law also eases the rollover rules from qualified plans, 403(b) and 457 plans; accelerates vesting of employer matching contributions; and offers a tax credit for small businesses that adopt a new qualified benefit or contribution plan, SIMPLE or SEP.

So, Congress has spoken. We’re sure to see technical corrections for some provisions soon, but most analysts believe that any substantive changes won’t be addressed for years. The best advice is to keep watching to see what happens and consult your tax professionals and financial advisors if you have any questions.

For more information on this topic contact Kelly Phillips Erb at taxgirl@erblaw.com.