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ANALYSIS OF SELECTED TAX LAW CHANGES
July, 2001
The past six months have seen sweeping changes in the Estate and Income tax laws, as well as new Regulations affecting distributions from IRAs and retirement plans. The many benefits afforded by the new tax provisions include the following:
The following will highlight major changes signed into law by President Bush, and new IRS taxpayer-friendly Regulations governing retirement assets.
I The Economic Growth and Tax Relief Reconciliation Act of 2001
A. Phase-out and Repeal of Estate Tax and Generation Skipping Transfer Tax; Increase in Gift Tax Exemption - The current estate tax exemption (or "Unified Credit") of $675,000 will gradually increase to $3.5 million in 2009, while the top estate tax rate, currently 55 percent, will decrease over time to 45%. These changes are illustrated below.
Estate and Gift Tax Rates; Unified Credit and GST Exemption Amount
|
Calendar Year |
Estate and GST Tax Death-time Transfer Exemption |
Highest Estate and Gift Tax Rates |
|
2002 |
$1 million |
50% |
|
2003 |
$1 million |
49% |
|
2004 |
$1.5 million |
48% |
|
2005 |
$1.5 million |
47% |
|
2006 |
$2 million |
46% |
|
2007 |
$2 million |
45% |
|
2008 |
$2 million |
45% |
|
2009 |
$3.5 million |
45% |
|
2010 |
N/A (taxes repealed) |
Top individual, rate under the bill (gift tax only) |
The exemption amount for gift tax purposes increases to $1 million in 2002, but does not increase thereafter. However, taxpayers may continue to make annual tax-free gifts of $10,000 per donee without affecting the lifetime $1 million exemption.
In 2010, the estate and generation-skipping transfer taxes are repealed, and the top gift tax rate will be the top individual income tax rate.
Sunset provision. The Act provides that the new tax scheme will not apply to gifts made, or estates of decedent's dying, after December 31, 2010. Without Congressional action, the pre-Act estate, gift and GST tax rates would be resurrected in 2011.
Caution: Wills which allocate assets between a spouse and non-spouse beneficiaries (e.g., children) based upon the Unified Credit amount, will need to be reviewed and perhaps changed. For example, a person who leaves the largest amount which may pass Estate tax free to his children, with the balance to his spouse would, as the Estate tax is repealed, be disinheriting his spouse.
Comment: Clients should be cautioned against making large gifts (i.e., over $1 million), particularly during these transitions years. When the estate tax exemption exceeds $1 million in 2004 and thereafter (and the gift tax exemption remains at $1 million) clients should hold assets until death to obtain step-up in basis (through 2009) and incur less or no transfer tax.
B. Phase-out of the State Death Tax Credit – In February, 2000, New York joined many other states in eliminating its own estate tax, in favor of adopting a "soak-up" tax. Under this tax scheme, New York imposes a tax on the estate of a decedent equal to the state death tax credit allowable against the Federal estate tax. The Pre-Act credit essentially resulted in no additional tax (as the Federal tax was reduced by the amount paid to New York).
The State death tax credit (allowable on the Federal Return) will gradually be phased out as follows: 2002, credit is reduced by 25%; 2003 credit is reduced by 50%; 2004, credit is reduced by 75%; and 2005, credit is replaced by a deduction for State death taxes.
Comment: Unless the New York estate tax statute is changed, New York will continue to impose a tax equal to the statutory credit in effect prior to the new Act, resulting in a higher overall state and federal tax. In 2004, for example, the top Federal estate tax rate will be 48%, but New Yorkers will be paying an additional 12% to the State, for 60% total.
Caution: In 2004, and thereafter, estates which maximize the Federal Unified Credit will incur a New York estate tax even if no Federal Estate tax is due (as the maximum exemption in New York is capped at $1 million).
C. Modified Carryover Basis - Estate taxes, once repealed in 2010, are replaced with a modified carryover basis rule. The tax basis "step-up" upon death (to continue through 2009) will be modified effective 2010, which will allow a basis increase of $1.3 million to certain assets, and an additional $3 million of basis may be added to assets transferred to a surviving spouse, such that a surviving spouse's property basis can be increased by $4.3 million. Gifts to a decedent from a non-spouse within three years before death are not eligible for the step-up in basis.
An Estate will also be allowed additional basis for "qualifying loss property" (e.g. capital loss carry forwards).
The Executor will have the responsibility of choosing the assets that will receive additional basis.
The current $250,000/$500,000 exclusion of gain realized on the sale or exchange of a principal residence will be available in conjunction with and in addition to the modified carryover basis rules.
Comment: Taxpayers should be advised to retain accurate records of cost basis (including assets acquired from a decedent).
D. Education Incentives
The Act takes tremendous steps to make education savings plans more attractive to families, and also increases tax breaks attributable to educational expenses.
1. Education IRA's - The current $500 annual contribution limit to Education IRAs (per beneficiary) is increased to $2,000 on behalf of each child beginning after December 31, 2001. A 6% excise tax is imposed on contributions in excess of the annual limit. Similar to IRA's, contributions counted toward any tax year will be permissible until April 15 of the following year, rather than being cut off on December 31. The AGI phase-out for married couples has also jumped to twice the range of single taxpayers (from $150,000–$160,000 to $190,000–$220,000).
Interest, dividends and gains can be withdrawn tax free to pay for school expenses. The definitions of "schools" and "expenses" have also changed, allowing for tax-free withdrawals for grades K–12, private or parochial, as well as college. Distributions not used for education purposes will be subject to income tax and a 10% penalty.
Also, penalty-free contributions to Education IRA's and qualified state tuition programs can be made in the same year.
2. Qualified Tuition Programs (Section 529 plans) - The new law liberalizes Section 529 plans in several respects.
Comment: After the Act's changes, Education IRAs and Section 529 plans will both offer tax-free earnings if payouts are made for qualified education purposes. Each however, will have unique benefits and limitations. An Education IRA, for example, can be used for elementary, secondary school expenses and college costs, but is limited to the annual $2000 contribution per beneficiary and AGI phase-outs. Section 529 plans, however, are not restricted as to contributions (subject to gift tax limitations), but must be used for higher education.
Section 529 plans offer an added advantage to New York taxpayers who may deduct up to $5,000 in contributions from New York taxable income ($10,000 for married couples).
3. College Tuition Deduction - Individuals (AGI below $65,000) and married couples (AGI below $130,000), beginning in 2002, and increasing in 2004 will be able to deduct $3,000 and $4,000 of qualified higher education expenses, respectively. A lessor deduction of $2,000 will be available in 2004 and 2005 for individuals with incomes up to $80,000 and married couples up to $160,000.
4. Student Loan Interest Deduction - Beginning after December 31, 2001, Student loan interest deductions of up to $2,500 annually will be available for the life of the loan (not during the first 60 months as had previously been the case). Additionally the income phase-out ranges for single taxpayers will be increased from $50,000 to $65,000 and for married taxpayers filing jointly from $100,000 to $130,000, and adjusted for inflation thereafter.
E. Pension and Individual Retirement Arrangement Provisions
The Act increases contribution limits, and portability for plan participants. Specifically, some of the highlights are as follows:
1. Traditional and Roth IRA Contribution Limits - These limits will increase from $2000 to $5,000 per year with annual adjustments for inflation after 2008 ($3,000 for 2002–2004; $4,000 for 2005–2007; and $5,000 for 2008 and thereafter).
2. Catch-up Contributions - Individuals 50 and over will be permitted additional contributions to a traditional IRA or Roth IRA of $500 in 2002–2005; $1,000 in 2006 and thereafter.
3. 401(K) Contribution Limits - Limits on salary reduction contributions for 401(K) plans, 403(b) and SEP plans will rise from $10,500 to $15,000 by 2006.
4. Defined Contribution Plan Limits - In 2002, the limits on annual additions to a defined contribution plan will rise to $40,000.
5. Roth 401(K) - A new savings plan called the Roth 401(K) will become available in 2006 to all workers whose employers offer 401(K) plans which will permit high income individuals to contribute on an after tax basis.
F. Income Tax Rate Cuts
The five existing tax brackets (i.e., 15%, 28%, 31% 36%, 39.6%) have been expanded to six, with the creation of a new 10 percent tax bracket, carved from the existing 15% tax bracket.
1. New 10 percent bracket - Effective for years beginning after December 31, 2000, the 10% rate bracket applies to the first $6,000 of taxable income for individual taxpayers ($7,000 for 2008 and thereafter) $10,000 of taxable income for heads of households, and $12,000 for married couples filing jointly ($14,000 for 2008 and thereafter).
2. Individual Income Tax Rate Reductions - The phase-in reduction of income tax rates begins in July, 2001, and is fully phased in by 2006. The table below shows the schedule of income tax rate reductions.
|
Calendar Year |
28% rate reduced to: |
31% rate reduced to: |
36% rate reduced to: |
39.6% rate reduced to: |
|
2001* - 2003 |
27% |
30% |
35% |
38.6% |
|
2004 – 2005 |
26% |
29% |
34% |
37.6% |
|
2006 and later |
25% |
28% |
33% |
35% |
-------------
*Effective July 1, 2001
3. Phase-Out of Itemized Deduction Limitations and Restrictions on Personal Exemptions - The limitations on itemized deductions and restrictions on personal exemptions will be phased out or reduced by one-third in taxable years beginning in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009, with the phase-out becoming fully effective after December 31, 2009.
4. Marriage Penalty Relief - The basic standard deduction for a married couple filing a joint return will increase to twice the basic standard deduction for an unmarried individual filing a single return, with the phase-in taking place over a four year period beginning in 2005, being fully phased in for 2009 and thereafter.
Similarly, there will be an expansion of the income level under the 15 percent tax rate bracket to an amount equal to twice that of single tax payers over the 2005-2008 period.
II Distributions from IRAs and Qualified Plans
Retirement assets are vulnerable to various tax impositions including:
A. Required Beginning Date ("RBD")
The RBD is April 1 of calendar year after the calendar year in which the IRA owner reaches age 70-1/2 (Caution: 1st and 2nd distribution must be taken in same year if you wait until RBD). Example: RBD for taxpayer who attained age 70 on June 30, 2001 will be April 1, 2002; but taxpayer who turned 70 on July 1, 2001 has an RBD of April 1, 2003.
Exception – RBD may be delayed for employees who are less than 5% owners of the employer and who continue working beyond age 70-1/2 (not applicable to IRAs).
B. New (proposed) Regulations for Distributions
On January 12, 2001, the IRS issued new proposed regulations which dramatically simplify the Minimum Distribution Rules applicable to IRAs and Qualified Plans. Effective Date: January 1, 2002, but taxpayers may use the new Regulations to calculate their 2001 distributions.
1. Uniform Distribution Period. Regardless of the age or identity of the designated beneficiary, taxpayers may base their Required Minimum Distributions ("RMD") on the following Uniform Distribution Table:
|
Age Distrib. Period (yrs) |
Age Distribution Period |
Age Distribution Period |
Age Distribution Period |
|
70 26.2 |
82 16.0 |
94 8.3 |
106 3.8 |
|
71 25.3 |
83 15.3 |
95 7.8 |
107 3.6 |
|
72 24.4 |
84 14.5 |
96 7.3 |
108 3.3 |
|
73 23.5 |
85 13.8 |
97 6.9 |
109 3.1 |
|
74 22.7 |
86 13.1 |
98 6.5 |
110 2.8 |
|
75 21.8 |
87 12.4 |
99 6.1 |
111 2.6 |
|
76 20.9 |
88 11.8 |
100 5.7 |
112 2.4 |
|
77 20.1 |
89 11.1 |
101 5.3 |
113 2.2 |
|
78 19.2 |
90 10.5 |
102 5.0 |
114 2.0 |
|
79 18.4 |
91 9.9 |
103 4.7 |
115 1.8 |
|
80 17.6 |
92 9.4 |
104 4.4 |
and older |
|
81 16.8 |
93 8.8 |
105 4.1 |
|
Exception: If the designated beneficiary is a spouse who is more than 10 years younger than the IRA owner, the actual joint life expectancy of the owner and spouse may be used.
Comment: The Term Certain, Recalculation and hybrid methods for calculating RMD will no longer be used. Clients already taking RMDs under these methods now have a "fresh start", usually resulting in a larger distribution period. It is suggested that such clients send a letter to the IRA Custodian or Plan Administrator indicating their election to use the extended distribution period.
2. Death Before Required Beginning Date: IRA owners must continue to insure that they have selected a Designated Beneficiary ("DB") to afford the DB the opportunity to take distributions over a period determined by his/her Life Expectancy. Without a DB (e.g., if the owner's estate is the beneficiary) distributions must essentially be made, and the IRA would be fully taxable, within five years after death.
3. Death After RBD: A DB may take distributions, following the death of the IRA owner, over a period determined by his/her life expectancy.
If the IRA owner failed to name a DB, distributions following death must be taken over the remaining life expectancy of the decedent (had he survived).
4. Trust as Beneficiary. As with the prior regulations, a trust may be a DB, and the life expectancy of the trust beneficiary may be used for determining the distribution period, provided certain requirements are met. However, the documentation requirements for trusts have been liberalized under the new regulations, essentially requiring that information regarding the trust be provided to the Custodian or Plan Administrator not later than 12/31 of the year following the year of death.
5. Reporting Requirements: For years beginning January 1, 2002, IRA Custodians will be required to report to the IRS and to the IRA owner the amount of the Required Minimum Distribution.
Comment: This will reinforce the IRS' ability to track RMD compliance, and impose the 50% excise tax for non-compliance. The IRS has assumed that this should not be a difficult task given the new Uniform Distribution Period applicable to all IRA owners. However, the IRS has failed to consider the complexity involved in distinguishing between the different distribution requirements applicable to spouses and non-spouses who inherit an IRA.
Further, the reporting requirements don't adequately address the fact that owners of multiple IRAs may satisfy the RMD requirement by taking the aggregate RMD from only one IRA.
For more information on these and related topics, please feel free to call Michael T. Nolan or Kevin condon at 631-694-2626 or 212-838-5555.
