2001 Tax Reform Act

          Starting in July, 2001, there is a new 10% tax bracket that applies as follows: 

           For single and joint filers, the $6,000 and $12,000 caps are raised to $7,000 and $14,000, respectively, starting in 2008. 

           This new tax bracket applies to the poor as well as Bill Gates, so everyone will benefit to the tune of a couple of hundred dollars.  Congress wanted this new bracket to take effect as of January 1, 2001, so there is a complex “credit” system now in place in which the Treasury will send checks out as soon as it can get its act together.

           Comment:  Shifting income to children over age 14 should become a new tax-planning tool since the income will be taxed at the 10% bracket for the first $6,000 of income (a $300 annual savings).

           Comment:  In reality, we have two income tax systems, the regular income tax system which the politicians discuss, and the AMT, which Congress uses to recapture taxes lost under the regular income tax system.  Generally, the regular tax system (rates ranging from 10% to 35% when the new legislation is fully phased-in) uses a series of exemptions and credits to lower taxable income.  The regular tax system can be thought of as a “net tax” system because it applies after all allowable deductions, exemptions and credits are taken into account.  In contrast AMT (with tax rates of 26% and 28%) is akin to a “gross tax” system since many of the benefits permitted under the regular tax system are disallowed under the AMT.  Taxpayers compute their taxes under both systems and pay the higher tax produced.  As the regular system tax rates are lowered, the AMT takes precedence, because its exemptions and tax rate structures have not been indexed for inflation.

           To illustrate: Suppose the single person making $250,000 a year in wages and the married couple earning $500,000 a year in wages also had $200,000 worth of incentive stock options (a preference item under the AMT which is added to income).  Note: For simplicity, there are no other income sources and no itemized deductions. TurboTax’s Tax Estimator software was used to determine these numbers.   The result:  There is no advantage to either.  Thus, what the tax cut offers, the AMT overrides.

           Note:  Those who claim an itemized deduction for their state taxes are also impacted by the AMT since those deductions are not allowed when calculating the tax.

Marriage Penalty Relief

 For those married couples filing jointly who use the standard deduction, there is an increase in the standard deduction to eliminate the so-called marriage penalty.  Unfortunately, this benefit is severely back-loaded: no change will occur until 2005.  Currently, two single individuals living together have a combined deduction that is greater than a married couple filing jointly.  However, the phase-in of this tax break occurs according to the following schedule (200% = parity with single filers):

            A similar adjustment to the 15% tax bracket will occur so that in 2008 and thereafter, the end-point (the last dollar eligible for the 15% bracket) for joint filers will equal 200% of the end-point for single filers.  The end-point for a married person filing a separate return will be 50% of the end-point for a joint filer.

           This so-called marriage penalty relief will not benefit most married couples who either own a home or live in a high-tax state since they will still need to itemize deductions to claim mortgage interest and property and state income tax deductions.

 Elimination of the Personal Exemption and Itemized Deduction Phase-Outs

           Currently, personal exemptions are phased-out for single taxpayers with adjusted gross incomes of $132,950 and $199,450 for joint filers at the rate of 2% for each $2,500 of AGI over these thresholds.  Itemized deductions are currently reduced by 3% for the amount of a taxpayer’s AGI exceeding $132,950, for both single and joint filers.

           Starting in 2006, the phase-out for personal exemptions and itemized deductions are eliminated according to the following table: 

           Comment:  This is a substantial benefit to those in higher income tax brackets but once again, the benefit is back-loaded, commencing in 2006.

Child Tax Credits

           Currently, taxpayers are entitled to a $500 tax credit for each child under age 17. These credits will be increased as follows: 

           These tax credits are refundable to the extent a taxpayer’s earned income exceeds $10,000 (indexed for inflation starting in 2002) as follows: 

           For families with three or more children, there is an alternative method to measure the refundable credit.  Credit amounts do not constitute income for purposes of qualifying for federally-funded assistance programs.  The child tax credit will apply against AMT beginning in 2002.

           Comment:  This tax break will benefit those in the lower income tax brackets, although once again, the tax break is phased-in slowly. 

Educational IRA’s

           The amount that can be contributed to an Educational IRA has been increased from $500 to $2,000 per beneficiary and the concept of “qualified education expenses” has been expanded to include elementary and secondary school expenses, including computer-related equipment and technology courses.  Importantly, the phase-out range for joint filers has been increased from $190,000 to $220,000 of AGI (as modified under the Educational IRA rules).  The age limitations for beneficiaries do not apply to special needs beneficiaries.  Corporations (including non-profit institutions) may make contributions to Education IRAs, regardless of their incomes).

           The Education IRA funds may be used along with the HOPE and Lifetime Learning Credits and there is no longer an excise tax when contributions are made to both an Educational IRA and to the same beneficiary under a qualified State Tuition program.

 Deductions for Student Loans; Employer-Provided Assistance

           The income eligibility phase-out for the interest deduction on student loans has been increased from $50,000 to $65,000 for single filers and $100,000 to $130,000 for joint filers.  These amounts will be adjusted annually for inflation after 2002.  There is no longer a restriction on the number of months that interest may be deductible; also, voluntary payments of interest are now deductible.  Employer-provided assistance now applies to both undergraduate and graduate education.

 Deduction for Higher Education Expenses

           There will be a new deduction for qualified higher education expenses paid during tax years 2002 through 2005 according to the following table: 

           Taxpayers cannot claim this deduction and either the HOPE or Lifetime Learning Credit under the same year.  No deduction is allowed for amounts which are tax-free under an Educational IRA or for tax-free interest from an educational savings bond.

           Comment:  These are serious tax breaks from which many taxpayers with education costs can benefit.  Note, even taxpayers whose income exceeds the limitations may have parents or relatives who can contribute to the Educational IRA’s for the taxpayer’s children; however, the maximum contribution for a beneficiary from all contributors is $2,000 per year. 

           Because of the interplay between this new tax break and the HOPE and Lifetime Learning Credit, each taxpayer will have to run the numbers with respect to his or her own situation to determine whether it is better to claim a HOPE or Lifetime Learning Credit or the new deduction for higher education expenses.