Analysis of the Economic Growth and Tax Relief Reconciliation Act of 2001.

The Economic Growth and Tax Relief Reconciliation Act of 2001 provides for a $1.35 trillion gradual reduction in taxes over the next 10 years. The law uses complex phase-ins and phase-outs and because of budget goals ends in ten years. Many of the tax benefits help specific groups, such as married couples, parents of young children and taxpayers saving for retirement or college. High-income taxpayers will also enjoy substantial tax savings toward the end of the 10-year period. The following tax provisions are gradually phased in starting in 2001 and ending in 2010.

New 10 percent tax rate

A new 10 percent tax bracket applies to taxable income up to $6,000 for single taxpayers, $10,000 for head of households and $12,000 for joint returns retroactive to January 1, 2001. These levels increase to $7,000 for singles and $14,000 for joint returns starting in 2008. The 15 percent tax rate remains the same except for carving out the bottom of the bracket for the new 10 percent rate.

Rate reduction rebate for 2001

Taxpayers should have received a lump sum rebate from the Treasury by mail to reflect the 5 percent rate cut. Taxpayers who filed after April 15,2001 because of an extension will receive their rebate in the fall. The rebate will be in lieu of the benefit of the 10 percent rate on 2001 tax returns and is based on 2000 returns filed in 2001. Single taxpayers will receive up to $300, head of household taxpayers $500 and joint taxpayers $600. Taxpayers with taxable income less that $6,000 for singles, or $10,000 for head of household and $12,000 for filing jointly will receive a lesser rebate.

Income tax rate reductions

Tax rate cuts will be the major portion of the new law and will cost $892 billion or 71 percent of the total cost of the tax bill. The new law will reduce and compress existing brackets and income will be taxed at six rates ranging from 10 percent to 35 percent. The four highest tax rates of 28 percent, 31 percent, 36 percent, and 39.6 percent are reduced gradually over six years. The current rates are reduced one percentage point effective July 1, 2001. There will be blended rates of 27.5 percent, 30.5 percent, 35.5 percent, and 39.1 percent for 2001. The rates will be reduced another percentage point both in 2004 and 2006 (except for the highest rate which will drop the most to 35 percent). Table 1 illustrates the phase-in of the income tax rate reductions.

Deloitte & Touche, a leading CPA firm, estimates the tax savings for taxpayers with various incomes, filing status and dependents as illustrated in Table 2.

Expanded and Increased Child Tax Credit

The child tax credit of $500 per child will double in ten years to $1,000. The credit will be increased to $600 in 2001, $700 in 2005, $800 in 2009, and $1,000 in 2010. Table 3 illustrates the increase in the child tax credit.

The new law also allows the child tax credit to he partly refundable to the extent that the earned income exceeds $10,000. For years 2001-2004, the refundable portion is limited to 10 percent of earned income over the threshold amount of $10,000. The percentage is increased to 15 percent starting in 2005.

Example: Mary and Ted, who have two children, have earned income of $14,000 in 2001 but no tax liability. The refundable provision allows a child tax credit refund of $400 ($14,000-$10,000) or $4,000 x.10 or $400. In 2005, the child tax credit increases to $600 or $4,000 x.15 or $600.

The refundable feature also benefits taxpayers with more than two children although current law allows for a refundable credit for these taxpayers' payroll taxes and the earned income credit significantly reduces or eliminates this credit for most taxpayers. The tax bill allows that the refundable credit will be the greater of (1) 10 percent of earned income, over $10,000 or (2) the excess of the taxpayer's social security taxes paid for the year over the taxpayer's earned income credit.

The child tax credit will be permanently reduced by the amount of the alternative minimum tax. There is a new provision under the act that also allows the refundable child tax credit against the alternative minimum tax liability after 2001. This will ensure that taxpayers will receive the refundable child tax credit and not be penalized because they are subject to the alternative minimum tax.

Dependent Care Credit Expansion

The Dependent Care tax credit will be expanded starting in 2002. It provides for an estimated additional $3 billion in tax relief for taxpayers. The amount of the expenses qualifying for the credit will increase from $2,400 to $3,000 for one qualifying dependent and from $4,800 to $6,000 for two or more dependents. The maximum credit would be increased from 30 percent to 35 percent of expenses. The new law also modifies the phase-down of the credit to $15,000 of adjusted gross income from the current $10,000. The credit percentage drops to 20 percent once adjusted gross income reaches $43,000. These provisions increase the minimum and the maximum credit for taxpayers with one child from $720 to $1,050 and $1,440 to $2,100 for two or more children. The Dependent care tax credit is not refundable so low-income taxpayers that owe no taxes are not eligible to receive any benefit. The credit will continue to be phased out for high-income taxpayers when modified adjusted gross income exceeds $75,000 for single tax payers and $110,000 for married taxpayers filing a joint return.

Earned income Credit Modifications The earned income credit calculation is simplified by changing the definition of certain terms such as earned income and foster child. The calculation of the earned income credit also replaces modified adjusted gross income with adjusted gross income. The beginning and ending of the phase-out range is increased by $1,000 for married couples from 2002 to 2004, by $2,000 from in 2008. The $3000 amount is to be adjusted upward annually for inflation starting in 2009. These changes will mean more low-income married taxpayers will be eligible for a larger or partial credit.

Expansion of Adoption Tax Credit

The new law permanently extends the adoption credit for children without special needs. The maximum credit is increased to $10,000 per eligible child including special needs children. Currently, the maximum non-refundable credit is $5,000 for regular children and $6,000 for children with special needs. A $10,000 credit is allowed in the year of adoption for special needs children even if the taxpayer has no qualified adoption expenses. The bill would also make the credit available to more taxpayers by raising the income eligibility limits. The starting point of the modified adjusted gross income phaseout range is increased to $150,000 from $75,000 under current law. These changes are generally effective for the 2002 taxable year. The provision for special needs adoptions that allows the credit regardless of whether the taxpayer has qualified adoption expenses is effective for the 2003 taxable year. The adoption tax credit will also be allowed permanently against the alternative minimum tax.

Education Savings Accounts 

There are a broad range of tax benefits to help pay education costs. Education IRAs are renamed educational savings accounts. The annual limit on contributions to educational savings accounts increases from $500 to $2,000 effective in 2002. The definition of qualified education expenses is expanded to include private or religious elementary and secondary school expenses. The phase-out range for married taxpayers filing a joint return is increased to $190,000 to $220,000 of modified adjusted gross income so it is twice the range for single taxpayers. New rules also allow a taxpayer to claim a Hope credit or lifetime learning credit for the same year they use the education savings account provided the distribution is not used for the same education expenses for which a credit was claimed.

College Tax Deduction 

The tax plan allows a new tax deduction for adjusted gross income for college expenses that could be claimed in lieu of the Hope Scholarship tax credit for taxpayers with incomes too high to benefit from the Hope credit. In 2002 and 2003, single taxpayers with adjusted gross income up to $65,000 ($130,000 on joint returns) would receive a maximum deduction of $3,000 per year. In 2004 and 2005, eligible taxpayers would receive a maximum deduction of $4,000. There is also a provision for higher-income taxpayers to get a partial $2,000 tuition deduction in 2004 and 2005. Taxpayers with adjusted gross income up to $80,000 for singles ($160,000 on joint returns) could deduct up to $2,000. The new law will not allow a taxpayer to get a tuition deduction and a Hope or Lifetime Learning credit in the same year for the student. The new deduction is scheduled to end in 2006.

Student Loan Interest Deduction 

The new law allows more students loan interest to be deducted for adjusted gross income. The new law will eliminate the $2,500 limit on deductions for interest paid on student loans. It also will eliminate the restriction on deductions to the first 60 months of repayment. The deduction will continue to be phased out for higher income taxpayers but the new law will raise the income-eligibility limits for the deduction. Currently, the deduction is phased out for single taxpayers with adjusted gross income between $40,000 and $55,000 and for married taxpayers with incomes between $60,000 and $75,000. The new law will increase the income phase-out range to $50,000 to $65,000 for single taxpayers and double to $100,000 to $135,000 on joint returns.

Prepaid Tuition Plans

Prepaid tuition plans would become a more attractive option to finance a child's college education under the new law. The new law expands the scope of qualified tuition plans and alters the tax treatment of distributions. The bill would make state sponsored prepaid tuition plans tax free starting in 2002. Current law requires tax to be paid on the increased value of the tuition contract once the child starts college. The same tax-free status would be extended to prepaid plans for private colleges starting in 2004.

Employer Provided Educational Assistance

The tax bill would make the tax exemption for employer provided educational assistance permanent and extend the benefit to graduate students stating in 2002. Currently, only undergraduate courses qualify for the $5,250 a year exemption, which is schedule to expire at the end of 2001.

Individual Retirement Accounts

Contribution limits for both traditional and Roth IRAs phase in over the next seven years and raise the annual contribution limit from $2,000 to $5,000 per year. In 2009, the limit will be annually adjusted for inflation in $500 increments. Taxpayers age 50 or over will be able to make additional catch-up contributions of $500 for years 2002 to 2005 and $1,000 for 2006 and later years. Table 4 shows the annual contribution limits for taxpayers under age 50 and those 50 or over.

Simple Individual Retirement Account Plans

The new tax law expands Simple IRA contribution limits over four years. In 2002 contribution limits increase $500 from $6,500 in 2001 to $7,000. The contribution limit increases $1,000 per year from 2003-2005 and is capped at $10,000. Starting in 2006, the bill adjusts contribution limits for inflation. Taxpayers age 50 and older are allowed additional contributions of $500 in 2002. The catch-up provisions increase an additional $500 every year from 2003-2006 reaching a maximum of $2,500 in 2006. Table 5 shows the annual contribution limits for taxpayers under age 50 and those aged 50 or over:

Employer Sponsored Retirement Plans

The new law also increases contribution limits from $10,500 to $15,000 by 2006 on salary reduction plans such as 401 (k), 403 (b) and 457 plans. There is a $500 increase in 2002 and additional annual increases of $1,000 starting in 2003 until $15,000 is reached in 2006. Starting in 2007, there is an adjustment for inflation in $500 increments. Taxpayers age 50 or over will be able to make additional catch-up contributions for 401 (k) and 403 (b) plans of an additional $1,000 per year starting in 2002 and reaching $5,000 per year in 2006. The tax law makes it easier to transfer assets between 401 (k) plans and similar plans offered to government workers and workers at nonprofit organizations when workers switch jobs. The new law also shortens the maximum vesting period for employer contributions from seven years to six years for plans with gradual vesting. For plans that defer all vesting until the end of the period, the vesting period is reduced from five to three years. Table 6 lists the contribution limits for taxpayers under age 50 and age 50 or over.

Retirement Plan Contribution Tax Credits

The new tax law gives low-income taxpayers a non-refundable tax credit to encourage them to participate in any tax saving retirement plan effective from 2002 to 2006. The credit rate varies from 50 percent, 20 percent, and 10 percent depending on the taxpayer's filing status and adjusted gross income. Single taxpayers with an adjusted gross income of less than $15,000 and joint filers less than $30,000 will receive a 50 percent credit for contribution amounts up to $2,000 or a maximum credit of $1,000. The credit phases out for single taxpayers with an adjusted gross income over $25,000, head of households over $37,500 and for joint filers more than $50,000.

Alternative Minimum Tax

The tax law provides for a small and temporary solution to the growing imposition of the alternative minimum tax to additional middle-income taxpayers. The new law will increase the AMT exemption by $4,000 on a joint return and for single taxpayers $2,000 only for years 2002-2004. This would increase the exemption for married taxpayers from $45,000 to $49,000 and for single taxpayers from $33,750 to $35,750.

Elimination of Itemized Deductions and Personal Exemptions Limitations

The new law gradually eliminates the overall limitation of itemized deductions for high-income taxpayers. The cutback reduction is reduced by one-third in taxable years starting in 2006 and 2007 and by two thirds in taxable years starting in 2008 and 2009. The overall limitation is eliminated starting in 2010.

The new law also phases out the limitations on personal exemptions. The personal exemption phase-out is reduced by one third in taxable years starting in 2006 and 2007 and by two-thirds in taxable years starting in 2008 and 2009. The phase-out is eliminated starting in 2010.

Marriage Penalty Relief

Dual income married couples will eventually receive modest tax relief which does not start until 2005. The standard deduction for a married couple filing jointly will increase until it becomes twice that of single taxpayers. The increase will be spread out over five years and does not become fully effective until 2009. The standard deduction for married couple filing jointly, which currently amounts to 160 percent of the standard deduction for singles, will rise to 174 percent in 2005. It will rise to 184 percent in 2006, 187 percent in 2007, 190 percent in 2008, and 200 percent in 2009. This provision will not benefit married taxpayers who itemize their deductions. The new law also gradually increases the size of the 15 percent bracket for married joint filers to twice the amount of the 15 percent bracket for single taxpayers starting in 2005 and ending in 2009.

Estate Tax Provisions

The new law includes gradual changes in the estate tax and gift tax rules with eventual repeal in 2010. The current estate tax exemption of $675,000 will increase to $1 million in 2002-2003, $1.5 million in 2004-2005, $2 million in 2006-2008 and $3.5 million in 2009. The top estate tax rate of 55 percent will drop to 50 percent in 2002 and an additional 1 percent each year until the rate drops to 45 percent in 2007. After 2009, the federal gift tax rate for gifts over one million will be lowered to the top individual income tax rate of 35 percent. In 2010, the basis of assets transferred at the decedent's death will generally be the lesser of the decedent's carryover basis or the fair market value at the time of death. A limited step-up in basis to the higher fair market value is allowed for assets transferred to a spouse of $3 million and $1.3 million to any other beneficiary.

Tax Planning 

The massive 2001 Tax Act made numerous changes to the tax law. Some of the changes will not become effective for years (if they ever become effective). There are many things that taxpayers need to do in order to prepare for the upcoming tax law changes. Examples of tax planning ideas many taxpayers should examine now are:

1) If possible, individual taxpayers should delay recognizing income until 2002 and later tax years to take advantage of the new lower rates being phased in.

2) If taxpayers have children they should consider starting an education IRA or Sec. 529 prepaid tuition plan (or both). The tax benefits of these types of plans have been significantly increased by the 2001 Act and taxpayers should take advantage of the tax breaks for future education expenses.

3) Qualified taxpayers with student loans paying nondeductible interest because the loans are over 60 months old should try to defer (e.g., go to graduate school part-time) payments until 2002. In 2002, the interest again becomes deductible as an above-the-line deduction.

4) Taxpayers over 50 years old should consider using the new "catch-up" provision for IRAs, and other pension plans.

5) High-income taxpayers need to review their estate plans. The new estate and gift tax provisions of the 2001 Act add a large amount of uncertainty into executing any current estate plan. In fact, because many of the new estate tax provisions will probably be revised before they go into effect, taxpayers will have to continually monitor estate plans for the next decade to ensure the plan accomplishes the desired goals.

Conclusion

Tax Planning will be complicated because of the many new phase-ins, phase-outs, income limits, and effective dates. The traditional tax strategy of deferring income to 2002 and accelerating deductible expenses to 2001 is appropriate because of the declining tax rates. The introduction of the new 10 percent tax rate provides opportunities for shifting family income. Taxpayers in the 39.1 percent bracket in 2001 may shift $6,000 of income to child 14 or older and be taxed at only 10 percent. Taxpayers with substantial assets will need to have a new estate tax plan which should be prepared by an estate planning attorney.

Radie Bunn, MS Tax, JD is a Professor at the School of Accountancy at Southwest Missouri State University in Springfield, MO.

G.E. Whittenburg, PhD, CPA, EA is a Professor at the School of Accountancy in San Diego State University in San Diego, CA.

Carol F. Venable, PhD, CPA is an Associate Professor at the San Diego State University in San Diego, CA.

TABLE 1

Tax Rate Reduction Schedule


Year            28% rate  31% rate  36% rate  39.6% rate

2001-2003       27%       30%       35%       38.6%
2004-2005       26%       29%       34%       37.6%
2006 and later  25%       28%       33%       35%
TABLE 2

Tax Savings With Marginal Rate Cuts


35%Taxpayer           Household  2001 liability  2001 liability
Profile                 Income      before cuts       after cut
Married                 $60,800          $4,010          $3,210
2 children under 17
Married                 $50,000         $26,407         $25,460
No children
Single                  $50,000         $31,102         $30,348
No children
Married              $1,000,000        S306,838        $302,233



35%Taxpayer          2011 liability
Profile              after all cuts
Married                      $2,310
2 children under 17
Married                     $22,589
No children
Single                      $27,767
No children
Married                    $259,234
TABLE 3

Child Tax Credit Increase


                CREDIT ALLOWED
YEAR              PER CHILD

2001-2004            $600
2005-2008            $700
2009                 $800
2010 and later     $1,000
TABLE 4

Annual Contribution Limits by Age


                      MAXIMUM            MAXIMUM
TAX YEARS STARTING  CONTRIBUTION  CONTRIBUTION 50 & OVER

2002-2004              $3,000             $3,500
2005                   $4,000             $4,500
2006-2007              $4,000             $5,000
2008                   $5,000             $6,000
TABLE 5

Annual Contribution Limits by Age


                      MAXIMUM             MAXIMUM
TAX YEARS STARTING  CONTRIBUTION  CONTRIBUTION 50 OR OVER

2002                   $7,000              $7,500
2003                   $8,000              $9,000
2004                   $9,000             $10,500
2005                  $10,000             $12,000
2006                  $10,000             $12,500
TABLE 6

Annual Contribution Limits by Age


                      MAXIMUM           MAXIMUM
TAX YEARS STARTING  CONTRIBUTION  CONTRIBUTION 50 & OVER

2002                  $11,000            $12,000
2003                  $12,000            $14,000
2004                  $13,000            $16,000
2005                  $14,000            $18,000
2006                  $15,000            S20,000