The Basics
The tax cut is here, but savings are years away
The new bill cuts rates, encourages education and retirement savings, and helps married couples and those with large estates. But long phase-ins, sunset clauses and a skew to big earners may leave you disappointed next April.
By Linda Stern
Cash those summer refund checks quickly when they come, folks, because the rest of the new $1.35 trillion tax cut might be slow to arrive and somewhat disappointing when it gets here.
Got an extension?
File your taxes online.
The most heralded breaks, including reduced rates and family-focused benefits, could be overshadowed by slow phase-in periods, automatic expirations of some provisions, a top-heavy skew and, perhaps most threatening of all, an alternative minimum tax that could snag almost as many taxpayers as this bill rewards.
"Most Americans will find the cuts smaller and slower than expected," said Mark Ernst, president of H&R Block, who called the bill "a triple for upper-income taxpayers, a double for middle-income families and a single for low-wage earners."
It was inside baseball that produced this package over a holiday weekend while the Senate was changing hands. President Bush got most of what he wanted; the final bill reflects his campaign outline. But Democrats were also able to get their way with some provisions targeted to the working poor. The question now is this: Did taxpayers get what they wanted?
Here's an explanation of the new tax law's major provisions, including what's may be in it for you. Look for more details on each facet of the tax law in the weeks to come.
Lower rates
The first, biggest and most progressive break is the creation of a 10% tax bracket for the first layer of income. Retroactive to the first of this year, this new bracket will affect the first $6,000 in income for singles, $10,000 in taxable income for heads of households and $12,000 for married couples. The 15% bracket takes hold once those levels are reached.
The 10% rate is responsible for the first-year rebate checks that the White House says will be in the mail by Oct. 1 -- and perhaps as early as July. (That assumes you filed your 2000 tax return on time; the rebate will be later if you filed later.) Those rebate checks will amount to $300 for most singles and $600 for most married couples who file joint tax returns.
But the long-term rate cuts hold more promise for individual taxpayers. While the 10% rate takes effect this year, the other lower rates will be phased in over five years. Once they are, the most common 28% rate will drop to 25%; the 31% rate falls to 28%; the 36% rate falls to 33%; and the top rate will drop from 39.6% to 35%.
Here’s how the rates phase in.
Tax rates under the new tax bill
Calendar year 2001-2003* 15% rate reduced to 28% rate reduced to 31% rate reduced to 36% rate reduced to 39.6% rate reduced to
2001-2003 10%** 27% 30% 35% 38.6%
2004-2005 10%** 26% 29% 34% 37.5%
2006 and thereafter 10%** 25% 28% 33% 35%
* Effective July 1, 2001
**For the first $6,000 of income for single filers, $10,000 for heads of households and $12,000 for married couples filing jointly. 15% bracket applies above those amounts. (In 2008, these income levels rise to $7,000 or singles and $14,000 for married couples. Heads of households will see no change.)
In addition, current limits that curtail the use of tax deductions and personal exemptions for high-bracket taxpayers will be phased out, starting in 2006 and ending completely 2010.
The upshot? By 2011, when all the elements of the new plan, including estate-tax repeal, are fully phased in (and assuming there aren't myriad other tax changes between now and then), the family of four earning $36,000 a year will save $1,925 in taxes; the same family earning $100,000 will save $2,790, and $400,000 earners will pocket an additional $13,989 a year, according to an analysis by Deloitte & Touche.
The AMT
But there's a big bad monster lurking just beneath the surface: The alternative minimum tax, a system originally designed to ensure that the wealthiest Americans couldn't avoid all income taxes, has grown into a trap for many middle- and upper-income families. And this bill basically fixes the problem with a Band Aid that is scheduled to fall off in four years. With new lower income-tax rates converging on AMT rates of 26% and 28% and only small changes to the AMT, as many as 13 million taxpayers could face the AMT, says CCH, a tax publishing firm.
The AMT requires taxpayers to calculate their income taxes two ways: the regular way, and then in an alternative way that uses a lower tax rate but expands the definition of taxable income to include items that would otherwise be deductible, such as real-estate taxes and some medical expenses. They then pay the higher total tax. (For a more detailed report on how the AMT works, see "Understanding the AMT and how to avoid it" and "8 ways to avoid the AMT sting.)
When the bill is fully phased in, a two-child family earning $115,000 could see $1,755 of their $2,769 benefit going back to the government to settle the AMT, CCH reports.
The new tax plan offers an additional AMT income exemption of $2,000 for singles and $4,000 for couples, but just through 2004. Congressional tax writers say they'll fix the problem by then, but with budget limits constraining any future tax-cutting action, don't take that promise to the bank with your summer refund check.
Family-friendly provisions
The new plan does give a boost to married couples, and an even bigger boost to those with young children, as long as both are patient enough to wait years for these breaks to become effective. By increasing the standard deduction for couples and broadening the 15% tax bracket for couples to fully double that of single filers, the new plan removes some of the pain of the so-called marriage penalty.
But hold on. Couples will have to defer gratification; this doesn't start until 2005 and is not completely phased in until 2009. (See tables, Source: Joint Tax Committee)
Here’s how this provision would work if 2001 brackets applied. For married couples filing jointly, the 15% bracket now stops at $45,200; for singles, the bracket stops at $27,050.
Expanding 15% tax bracket for married couples filing jointly
Year Percentage of single bracket Top point of bracket Tax savings
Under Old law 167% $45,200 0
2005 180% $48,690 $523.50
2006 187% $50,583 $807.53
2007 193% $52,206 $1,050.98
2008 and after 200% $54,100 $1,335.00
Here’s now the standard deduction for married couples would change if 2001 deductions applied.
Expanding standard deduction for married couples
Year Percentage of single standard deduction Under new law Tax savings at 15% tax rate
Until 2005 167% $7,600* 0
2005 174% $7,917** $47.55
2006 184% $8,372** $115.80
2007 187% $8,509** $136.28
2008 190% $8,645** $156.75
2009 and after 200% $9,100** $225.00
*Will be adjusted annually for inflation.
**Based on $7,600 standard deduction.
The big savings? When this is fully phased in, couples earning $30,000 a year and those earning $50,000 a year will each save at least $225 annually because of the standard deduction increase, says CCH. (It could be more ,depending on inflation adjustments.) Couples earning $100,000 will save $1,577, because they'll also benefit from the lowered tax brackets.
Child credits improve, too. The $500 tax credit per child will rise to $600 this year and then again to $700 in 2005. In 2009, it reaches $800, and by 2010 it becomes $1,000. The new tax plan allows the lowest income families to get some of this credit returned to them if they don't earn enough to pay income taxes.
Starting next year, the child-care credit gets bigger, too, increasing the maximum amount of eligible employment-related expenses from $2,400 to $3,000 for one child and from $4,800 to $6,000 for two or more.
Education
Those nifty child credits disappear when kids turn 18 and start demanding cars, prom clothes and college educations. But a host of improved tuition tax breaks will ease that burden.
Starting with 2002, annual contribution limits on education IRAs will rise from $500 to $2,000, and married couples will be able to have as much as $220,000 of modified adjusted gross income and still take tax breaks for these accounts. Use the proceeds to pay for college, and you'll never have to pay income tax on the money earned within the account. Moreover, in a move that voucher-vending Republicans love and most public-school-preferring Democrats hate, the bill would allow families to use those funds for private elementary and high school tuition as well as college costs.
Also beginning in 2002, taxpayers can deduct more in higher education costs, and they can deduct them even if they don't otherwise itemize their deductions. The new maximums are as follows: In 2002 and 2003, taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 for married couples filing joint returns) are entitled to a maximum deduction of $3,000 per year, and taxpayers with higher incomes would not get any deduction. In 2004 and 2005, taxpayers with adjusted gross income that does not exceed $65,000 ($130,000 for married taxpayers filing joint returns) are entitled to a maximum deduction of $4,000 and taxpayers with adjusted gross income that does not exceed $80,000 ($160,000 in the case of married taxpayers filing joint returns) are entitled to a maximum deduction of $2,000.
Perhaps one of the best educational goodies in the bill is a determination that earnings of pre-paid tuition plans (including the popular "529 plans") are tax-free forever, and don't, as is currently the case, become taxable at the worst possible time: just when the student needs the money for college. Finally, the bill extends tax deductions for interest on student loans to higher income taxpayers.
The estate tax
Death and taxes may be sure things, but there's nothing certain about this package's repeal of the estate tax. It takes nine years to take full effect. Then, after the 10th year, the estate tax will come back unless Congress again votes to repeal it, because of budgetary sunset laws that force revenue losers to expire automatically. "Nine years is a near-eternity in the universe of tax legislation, and any number of reasons might cause Congress to slow or halt the progress toward total repeal," says Bruno Graziano, a senior estate tax analyst for CCH.
In the years leading up to the total repeal, top estate taxes -- which affect just 1 in 100 deaths, according to CCH -- will phase down, according to this schedule:
New estate tax rates
Year Top tax rate on estates
2001 55% of excess over $3 million
2002 50% of excess over $2.5 million
2003 49% of excess over $2 million
2004 48% of excess over $2 million
2005 47% of excess over $2 million
2006 46% of excess over $2 million
2007 45% of excess over $2 million
2008 45% of excess over $3.5 million
2009 No estate tax
2010 Without new legislation, return to 2001 status
This quirky schedule will cause annual timing shifts that has prompted some analysts to envision dying millionaires being out on year-end respirators so they can make it into one more new year and save their heirs some money.
Even during that one shining year when the estate tax disappears, it leaves some tax burdens and serious dislocations in its wake. To compensate for the lack of an estate tax, Congress limited the amount of capital gains that can be passed on tax-free. The so-called "step up in basis" which allows heirs to value inherited securities when they inherit them would be capped at $1.3 million for most heirs, $4.3 million for spouses. Someone who dies with a big stock portfolio might end up costing their heirs more in capital-gains taxes than they would have paid in estate taxes, said William Massey, an estate tax specialist with RIA, a tax research firm.
Even weirder, this legislation unlinks gift and estate taxes with the effect that the wealthy who receive gifts from parents and grandparents could end up paying as much as 35% in taxes on money that they receive as gifts, even though they could ultimately inherit the same cash tax-free. So much for the "let them enjoy it while I'm alive" scenario.
Congress somehow managed to eliminate the estate tax AND create a windfall for estate-tax attorneys. With this phase-out schedule in effect, those wealthy enough to worry about estate taxes will probably have to redo their long-term plans every year, instead of just once.
At least until the next tax bill passes. This new plan will require further legislation to either extend many of its provisions or to fix them. Watch this space, but don't worry: You'll at least have your summer rebate checks in hand before then. |
