New Tax Law, New Financial Planning: New Options for Education, Retirement

Article excerpt

Congress adopted the Economic Growth and Tax Relief Reconciliation Act of 2001 (the Act) on May 26, 2001. These tax cuts are the largest since 1981. President Bush asked Congress to focus on a short list of essential tax reductions and to defer action on other tax changes until later in 2001 or next year. Congress responded by adopting a modified version of the president's core tax cut proposals, which include:

* Significant tax rate reductions;

* Lower taxes for married couples;

* A substantial increase in the child credit; and

* Repeal of the estate tax.

In addition to adopting the largest of the president's tax cut proposals, Congress included a substantial number of new education incentives and a package of pension reforms that provides significant increases in the contribution limits for IRAs, Roth IRAs, 401(k) plans, and other retirement savings vehicles.

Income Tax Reductions. The 2001 Act centers on across-the-board tax rate reductions, including an immediate rebate. It eliminates both the phase-out of personal exemptions and the 3% reduction of itemized deductions for high-income taxpayers. For families, it provides a more generous 15% tax bracket and a higher standard deduction for married couples, increases the child credit to $1,000, and expands a number of education incentives.

The Rate Cuts: Over time, the Act lowers the 28%, 31%, 36%, and 39.6% brackets to 25%, 28%, 33%, and 35%. It also creates a new bracket by splitting the existing 15% bracket into two brackets--a 10% and a 15% tax bracket. The Act provides an immediate tax benefit by making the new 10% bracket retroactive to the beginning of 2001. The 10% bracket encompasses the first $6,000 ($7,000 after 2007) of taxable income for singles and the first $12,000 ($14,000 after 2007) for married couples filing jointly.

Rate reductions in higher brackets also begin in 2001 and will be fully phased in by 2006. The table on page 21 shows the applicable rates for each of the current brackets as they phase in. Note that from any one year to the next, the drop in rates is typically no more than one percentage point.

The Act's new 10% tax bracket provides immediate relief this year to everyone who pays income taxes. This retroactive relief, designed to boost the economy by quickly putting spending money back into the pockets of taxpayers, provided modest first-year tax savings, ranging from $300 for singles to $600 for married couples.

The immediate tax benefit created by the new 10% rate bracket came in the form of a credit, distributed to most taxpayers by check before October.

Savings in ensuing years will become more dramatic, with further rate reductions scheduled for higher tax brackets. For example, a couple who this year earn $150,000, might reasonably expect a reduction in 2001 taxes of $950. But in 2010, they could expect a savings of about $3,800. This includes additional savings from new "marriage penalty" relief provisions.

Planning for Rate Drops: A basic strategy of personal tax planning requires consideration of deferring income and accelerating deductions. If you report taxable income during the years in which marginal tax rates are dropping, you can expect to realize tax savings under the Act; however, with planning, these potential savings can be maximized. As with any analysis of a deferral opportunity, consideration must be given not only to the potential tax savings from shifting income or deductions, but also to the attendant economic risks and alternative minimum tax (AMT) exposures. Generally, taxpayers who are not subject to AMT should consider deferring income to years that have lower marginal rates and accelerating deductions to years with higher rates. These measures will net the largest savings.

Marginal rates will be lower in 2002 than in 2001, so taxpayers can expect a benefit from deferral of income. Benefits from income deferral will occur each time marginal tax rates are reduced under the Act. …