On June 7, 2001, President Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (“Act”), which substantially changes many of the federal tax laws. Some of the major changes include a reduction in income tax rates, the elimination of the estate and generation-skipping transfer (“GST”) taxes after 2009, elimination of income limitations for itemized deductions, and greater flexibility and higher contribution allowances for retirement plans. It is important to note that the Act also includes a “sunset” provision, often included in federal budget acts, that causes the Act’s changes to become ineffective in ten years. Thus, unless Congress reenacts all or some of the Act’s provisions, in 2011 the pre-Act tax laws will once again take effect. Following are some of the most important changes made by the Act:
Income Tax Changes
- A new 10% rate bracket is added retroactive to January 1, 2001. As a result, most taxpayers will receive a credit of $300 if single, $600 if married filing jointly, or $500 if head of household, to be refunded before October 1, 2001.
- The income tax rates for individual taxpayers are gradually reduced as follows:
(i) the current 28% rate decreases to 25%;
(ii) the current 31% rate decreases to 28%;
(iii) the current 36% rate decreased to 33%; and
(iv) the current 39.6% rate decreased to 35%.
- The “marriage penalty” reflected in the tax rates and standard deduction allowances is phased-out beginning in 2005. Regarding tax rates, the applicable phase-in percentages for married couples are 180% of the size of the rate bracket for an unmarried individual beginning 2005, 187% in 2006, 193% in 2007, and 200% in 2008 and later. For the standard deduction, the applicable phase-in percentages for married couples are 174% of the deduction amount for taxpayers filing a single return in 2005, 184% in 2006, 187% in 2007, 190% in 2008, and 200% thereafter.
- The alternative minimum tax exemption amount for individuals is increased.
- The income limitation for itemized deductions is phased out beginning in 2006 and ending in 2009.
- Rates for the kiddie tax, the accumulated earnings tax and the personal holding company tax are reduced to match reductions in individual income tax rates starting in 2001.
Estate, GST and Gift Tax Changes
- The estate tax and GST tax are repealed after 2009. The gift tax is retained but the lifetime gift exemption is increased to $1 million in 2002.
- The estate tax and GST tax exemption amounts are increased to $1 million in 2002, $1.5 million in 2004, $2 million in 2006, and $3.5 million in 2009.
- The maximum estate and gift tax rate will decrease to 50% in 2002, 49% in 2003, 48% in 2004, 47% in 2005, 46% in 2006, 45% in 2007-2009. Beginning in 2010, the top gift tax rate will decrease further to equal the top individual income tax rate and the estate tax will be repealed.
- A decedent’s heirs will receive a carryover basis in the decedent’s assets rather than the stepped-up basis previously implemented.
Child Care and Education Related Changes
- The education IRA contribution limit is increased to $2,000 per beneficiary. The Act also allows such IRAs to include contributions made for elementary and secondary school expenses. Beneficiaries of education IRAs may claim Hope and Lifetime Learning credits as well, if such beneficiaries are otherwise qualified.
- Employers may take a tax credit for 10% of certain child care resource and referral expenditures and 25% of expenditures to acquire, operate, maintain, or contract with a qualified child care facility to provide child care services to employees. The credit is capped at $150,000.
- Certain education expenses paid from 2002 through 2005 may be deducted.
- The student loan interest deduction income phase-out ranges are increased to $60,000-$75,000 for single filers and $100,000-$130,000 for married taxpayers filing jointly.
Changes Effecting Qualified Retirement Plans, 403(b) plans and 457 plans
- Participant pre-tax deferral contribution limits for 401(k), 403(b) and 457 plans are increased to $11,000 in 2002, $12,000 in 2003, $13,000 in 2004, $14,000 in 2005 and $15,000 in 2006 (cost of living adjustments provided thereafter in $500 increments).
- Participant pre-tax deferral contribution limits for SIMPLE IRA and SIMPLE 401(k) plans are increased from $6,500 in 2001 to $7,000 in 2002, $8,000 in 2003, $9,000 in 2004, and $10,000 in 2005 (cost of living adjustments provided thereafter in $500 increments).
- A variety of technical changes create opportunities for increased employer and participant contributions to employer-sponsored qualified plans (and 403(b) plans), including beneficial changes in the employer deduction rules, changes in the definition of compensation, increases in the amount of compensation that employers may consider for employer deduction and plan benefit purposes (from $170,000 in 2001 to $200,000 in 2002), and compliance testing simplification. Also, for defined contribution plans (e.g., 401(k), profit sharing and money purchase pension plans), the “annual additions” limit of 25% of compensation is increased to 100%, and the “annual additions” dollar limit increases from $35,000 in 2001 to $40,000 in 2002.
- Individuals age 50 and older may make additional “catch up” contributions to an IRA, SIMPLE IRA, SIMPLE 401(k) plan, qualified plan, 403(b) plan, 457 plan or SEP plan. The amount of the catch up differs depending on the type of plan.
- Additional changes impact defined benefit pension plans, including an increase in the annual benefits limit from $140,000 to $160,000 in 2002. This limit is reduced only if benefits start prior to age 62, and it is increased if benefits begin after age 65. The Act also provides for enhanced notice requirements related to significant reductions in benefit accruals, increases the current-liability full funding limit, provides flexibility regarding the rules related to the excise tax on nondeductible contributions, and tightens plan valuation requirements.
- Traditional and Roth IRA contribution limits increase from $2000 in 2001 to $3,000 for 2002 through 2004, to $4,000 in 2005 through 2007, and to $5,000 in 2008 (cost of living adjustments provided thereafter in $500 increments); annual education IRA contribution limits increase from $500 to $2,000 per beneficiary effective in 2002, and education IRAs are expanded to include elementary and secondary school expenses after 2001.
- Beginning in 2003, qualified defined contribution, 403(b) and 457(b) plans may include traditional IRA or Roth IRA accounts.
- 401(k) plans must provide for enhanced vesting schedules for employer matching contributions (either a three year cliff vesting schedule or a six year graded vesting schedule).
- Employers may deduct dividends that are paid to an ESOP and reinvested in employer securities at the election of ESOP participants or beneficiaries. · Sole proprietors, partners and S-corporation owners will have the same access to qualified plan loans as other participants in their plans.
- The ability to roll over benefits among all employer sponsored retirement plans and IRAs is enhanced, including transfers of after-tax monies in qualified plans.
- Top-heavy rules are modified, including changes in the definition of "key employee" and repeal of the four-year look-back rule for determining who is a key employee. In addition, the five-year look-back rule for counting distributions in the top-heavy test is shortened to one year for distributions other than in-service distributions, and certain safe-harbor 401(k) plans will be deemed not to be “top-heavy.”
The phase-out nature of many of the Act’s provisions, the sunset provision, and the possibility that a new Congress or a new Presidential administration may cause repeal of the Act even before 2011 add uncertainty and additional complexity to tax planning. Such complexity makes it especially important that you consult qualified tax professionals to provide advice regarding the new tax laws. Parker Poe would be glad to discuss with you the effect that these tax changes have on your personal or business planning.