AnnuityAdvisors - Where advisors go for advice
By Margaret A. Kruse
Product Tax Counsel
(502) 582-7945

Broker/dealer or agent use only

The Economic Growth and Tax Relief Reconciliation Act of 2001 was signed into law on June 7, 2001. It reduced the income tax rates, expanded opportunities for pension and education savings and repealed the estate tax.

Tax Rate Reduction
The new law provides that a new 10% tax bracket will be added this year on the first $6,000 of income for a single person, $10,000 for a head of household and $12,000 for a couple who is married, filing jointly. This reduces the tax on those incomes from 15% rate to a 10% rate. The 5% reduction in rate will mean a $300 tax cut for single people, $500 cut for heads of household and $600 cut for couples who are married filing jointly.

Instead of changing withholding for the year, Congress decided to refund this money to taxpayers in the fall of 2001. People who filed a tax return for year 2000 by April 16 got a check for this tax reduction. That is, single filers will get a check for $300, heads of household will get a check for $500 and joint filers will get a check for $600.

The checks were sent out in order of the last 2 digits of a person’s Social Security number. For married couples who filed jointly, the IRS will use the top Social Security number on the return. The checks were all distributed by the end of September.

People who got an extension to file their 2000 tax return after April 16 will receive their check later.

If a person’s income did not reach the $6,000, $10,000 or $12,000 mark, they may receive a reduced check. If a client didn’t file a return last year or changed status from 2000, the refund will be reconciled on the 2001 return.

The 10% bracket will be included on the rate schedules beginning next year. This 10% bracket will not be indexed for inflation until after 2008.

The second component of rate reduction is the reduction of the tax rates above the 15% rate. The rates will fall according to this schedule:

Calendar Year 28% rate reduced to: 31% rate reduced to: 36% rate reduced to: 39.6% rate reduced to:
2006 and later25%28%33%35%

Note that in 2001, the 1% reduction is only good for half a year. Therefore, the rates will be a blended rate giving a .5% reduction. The rates for 2001 are 15%, 27.5%, 30.5%, 35.5% and 39.1%.

Deferring ordinary income until 2006 (for example, through an annuity) will allow people to recognize income at a lower rate. (This assumes, of course, that they will not jump into a higher marginal bracket in the mean time.)

Capital gains rates will not change—they are still 10% for people otherwise in the 15% bracket, and 20% for people in the brackets above 15%. As the ordinary income rates fall, ordinary income improves somewhat relative to capital gains. For example, after 2006 capital gains will be taxed at 20% and ordinary income at 25% (instead of the current 28%). Of course, Congress may change capital gains rates before then.

Phase-out of itemized deductions eliminated
Currently, itemized deductions are phased out in the amount of 3% of the amount over a phase-out threshold of $132,950. (No more than 80% of itemized deductions can be phased out.) This phase out will be eliminated in stages beginning in 2006 and fully eliminated beginning in 2010. So higher-income clients will no longer be subject to this “stealth tax”: They will be able to keep all of their itemized deductions.

Phase-out of Restrictions on Personal Exemptions
Similarly, clients with higher incomes had the benefit of their personal exemptions phased out under the old law. This second “stealth tax” will also be reduced beginning in 2006 until it is eliminated in 2010. Higher-income clients will be able to use all of their personal exemptions.

Child Tax Credit
The child tax credit will increase to $600 for this year, and continue to increase until it reaches $1,000 in 2010.

Marriage Penalty Relief
There are 2 big changes to relieve the marriage penalty. First, the standard deduction for people who are married, filing jointly will gradually increase, beginning in 2005, until it reaches twice the standard deduction as that for single filers in 2009. This provision may not be of much help to high-income taxpayers, who statistically would have so many itemized deductions that they would not use even the new, higher the standard deduction.

The second big change is that the 15% rate bracket for joint filers will gradually expand, again beginning in 2005, until it is twice as large as the 15% bracket for single filers in 2008.

For both these cases, the actual amount of the deduction or the bracket is not known right now—the brackets and deduction are adjusted for inflation each year.

Note that these two provisions do not specifically address the marriage penalty. They give benefits to all married taxpayers, even those who already enjoy a marriage “premium” because only one spouse works.

IRA and Pension Changes: More Opportunities

Larger IRA Contributions. IRA contribution limits, for traditional, Roth, or a combination of both, are going to increase from the current $2,000 along this schedule:

2002-2004: $3,000
2005-2007: $4,000
2008 and thereafter: $5,000. This amount will be indexed for inflation from 2009.

Larger 401(k) and 403(b) deferrals. Currently an employee can elect to defer $10,500 into a 401(k) or a 403(b) plan. This will increase as follows:


The limit will be indexed for inflation after 2006.

Larger SIMPLE Plan contributions. Right now the limit is $6,500. It will increase along this schedule:


After 2005 the limit will be indexed for inflation.

Catch up contributions for people over 50. Congress added new “catch up” provisions for IRAs as well. People over age 50 will be able to contribute an additional $500 annually over the regular limit from 2002-2005, and an extra $1,000 over the limit from 2006 and thereafter. The primary purpose is to help women who spent time out of the work force (and thus missed years of contributions) to increase their retirement savings faster. However, it is available to all earners over 50, not just people who missed earlier contribution opportunities.

There are also catch-up provisions for people over 50 who are contributing to a 401(k), 403(b) or SIMPLE plan. These additional contributions are as follows:

YearSIMPLE extra401(k) and 403(b) extra

After 2006, the catch-up amount will be indexed for inflation in $500 increments.

Tax credit for low-income contributors. Another new provision allows certain low-income taxpayers to get Uncle Sam to contribute indirectly to their retirement accounts. They will receive a tax credit (as opposed to deduction) for their contribution to their IRA, 401(k), 403b) or 457 plan. Low-income taxpayers are eligible for a tax credit up to a percent of the first $2,000 they contribute.
The credit is as follows:

If : Individual taxpayer MAGI Or if: Joint taxpayer MAGI Then: Credit against the first $2,000 of contribution

The biggest tax credit allowed would be $1,000 (i.e., 50% of $2,000). The full $1,000 would not be available to many taxpayers. That would only apply to singles with less than $15,000 AGI or joint filers with less than $30,000 AGI who had a tax liability of more than $1,000 and who contributed the full $2,000. This provision only applies between 2002 and 2006.

Other limits increased: Faster Vesting: Beginning for contributions after 2002, the longest vesting schedules employers may require for employer matching contributions will be shortened. (Employer matching contributions are matches to an employee’s contribution or an employee’s elective deferral into a plan.) The 5-year 100% vesting cliff will shorten to 3 years. The sliding vesting schedule will shorten to 20% vesting each year beginning with the second year of service (instead of the third). Under the sliding schedule, an employee will be fully vested after six years.

MRD Tables may be revised. Congress has mandated that the IRS update the Minimum Required Distribution life expectancy tables to reflect current mortality, although they did not give the IRS a deadline. Since life expectancies are longer, minimum distributions under these tables may fall. However, the assumptions on life expectancy under the new Uniform Table published in the new Proposed Regs in January were already generous. We’ll have to wait to see how new mortality tables will impact MRDs.

Deemed IRAs: Beginning in 2003, Qualified Plans, 403(b) plans and 457 governmental plans can let employees make voluntary “deemed IRA” contributions to their qualified plans. These Deemed IRA amounts will be accounted for separately and are subject to IRA contribution limits. These deemed IRA contributions will not be counted in the non-discrimination testing of the qualified plan. Essentially, this sounds to me like an employee has the option to make his IRA contribution to his qualified plan to get the benefit of the investment options in that qualified plan. Also, the employer can offer employees the opportunity for more contributions without those contributions being counted in non-discrimination testing. However, it will require trustees to keep wholly separate IRA accounting on these accounts. We’ll have to wait to see if this is something qualified plan trustees are willing to do.

Pensions are more portable beginning 2002: Roth 401(k) and 403(b) elective deferrals beginning in 2006. Beginning in 2006, employers will be able to offer Roth-type elective deferrals into 401(k) or 403(b) plans. These contributions will be taxable to the employee, but the accounts will grow tax deferred and qualified distributions will be tax-free.

Repeal of the Estate Tax The Estate Tax and the Generation Skipping Transfer Tax will be phased out during the next several years, until it is fully repealed in 2010. There has been a lot of press emphasizing that the repeal only lasts for one year, when the new tax law expires. If Congress took no further action, we would return to the tax law of today in 2011. We will wait to see what happens. However, the “sunset” provision was required by law—it is not a deliberate decision by Congress to retract the repeal. I think it is likely that Congress will extend the repeal come 2010, or if they need more revenue, they may bring back a less onerous estate tax, perhaps with high exemption levels.

The Gift Tax is still in effect, although there are some changes to this as well. Aside from annual exclusion gifts (currently $10,000 per person per year) each person will have a $1,000,000 lifetime exemption beginning in 2002 for other gifts. This limit will help prevent major income shifting within a family, which is an even more valuable technique with the new 10% income tax bracket. Gifts above the $1,000,000 will be gift taxed, although the top rate for the gift tax will fall over the next ten years to the top individual income tax rate.

The estate tax will shrink in both directions. First, the exemption amount will increase, and second, the top tax rate will fall.

Changes for 2002. For a client who dies or makes gifts in 2002,
The unified credit exemption equivalent for the estate and the gift tax will increase from $675,000 to $1,000,000.

The top estate and gift tax rate will drop to 50%. This will necessarily drop the GST tax rate to 50% as well.

The 5% surtax on estates between $10,000,000 and $17,000,000+ will be repealed.

The state death tax credit will be reduced by 25%.

After 2002. The $1,000,000 exemption for the gift tax will remain. However, the estate tax exemption will increase and the highest estate and gift tax rate will fall along this schedule:

YearEstate and GST tax death transfer exemptionHighest estate and gift tax rate
2010Estate and GST tax repealedGift tax highest rate is the highest income tax rate (probably 35%).

The state death tax credit will reduced annually until it’s gone in 2005, and will be replaced with a deduction after that. Since many states have “pick-up” taxes equal to the federal credit allowed, they will lose revenue as the credit shrinks. Look for states to change and possibly even increase their death taxes to get that revenue back.

When the estate tax is repealed beginning in 2010, there will be a new carry-over basis regime which determines the basis of the property in the hands of the recipient.

Currently a beneficiary of a gift during life carries over the basis of an asset given by a donor. This will be the general rule for transfers at death, too, beginning in 2010. Generally the recipient of the inheritance will carry over the owner’s basis.

This is something of a substitute tax. The recipient’s basis, of course, will determine whether the recipient has a capital gain or loss for income tax purposes when he or she sells the property. If a recipient receives property with a built in gain, he also inherits an income tax liability which will be recognized when the recipient sells the property.

If the asset had a built-in loss when the owner died (the value of the asset has fallen since the owner bought it), the recipient will not carry over the built-in loss. Instead he will have a basis equal to the fair market value immediately before the owner’s death. Losing that built-in loss is painful: if the property had been sold before the owner died it would have generated a capital loss which could reduce income taxes. So to make up for this, that loss amount can be added to basis of other assets.

There is some relief to the carry-over basis, though. Each estate will get $1,300,000 of basis to allocate to assets. (By raising the basis, you will reduce the capital gain when the recipient sells, and thus the income tax on the gain.) In addition, the estate will get another $3,000,000 of basis to allocate to assets going to a spouse. Assets going to a spouse can be increased by both the $1,300,000 step-up amount and the additional $3,000,000 spousal step-up amount. (These amounts will be indexed for inflation after 2010.)

The executor can decide which assets will get their bases bumped up. However, assets can’t get their bases increased above their fair market value. For example, if someone dies with an asset valued at $500,000 but with a basis of $200,000, the executor can only allocate $300,000 basis to bring the basis up to fair market value. You can’t bump up the basis to $1,500,000 (the original $200,000 basis + $1,300,000 of additional basis) so that the recipient gets a big capital loss when she or he sells (or, put another way, will have no capital gain until the fmv increases above $1,500,000).

You can’t allocate basis to assets which the decedent received by gift within 3 years of death. So son won’t be able to gift low-basis stock to dying mother, and inherit it right back after she dies with a new, high basis. Spouses can do this, though.

The estate also gets more basis to distribute from any of the decedent’s unused capital loss carryforwards and net operating loss carryforwards of the decedent.

You wouldn’t allocate basis to an annuity, IRA or qualified retirement account, because their gains are Income in Respect of a Decedent, not capital gain.

Note that a major objection to annuities is that unlike capital gains, they do not get a basis step-up at death. But after 2010, many capital assets of larger estates will not get a basis step-up, either.

Since there will no longer be a “fresh start” on basis when the owner dies, it is important for your clients to track basis on their assets.

Education Incentives
The new tax law is loaded with education incentives. This is not a comprehensive discussion of the new tax law. Rather, I have highlighted points I think will be most useful to brokers and agents. It is not intended to be legal or tax advice. Consult a qualified tax advisor regarding specific circumstances.

Last Updated: 12/15/2002 11:50:00 AM