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Overview of 2001 Tax Relief Act
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Subjects Covered:
Advance Refund Checks Due Later This Year The legislation reduces the lowest rate by creating a new 10% rate bracket below the current 15% rate bracket, effective retroactively to January 1, 2001. The 10% rate applies to the first $6,000 of taxable income for single filers, the first $10,000 for heads of households, and the first $12,000 for joint filers. Since this new rate is five percentage points less than the former lowest rate, and applies retroactively, the effect will be to reduce individual federal income tax for 2001 by a maximum of $300 for single filers (5% of $6,000), $500 for heads of households (5% of $10,000), and $600 for joint filers (5% of $12,000). Lawmakers decided to implement the new 10% rate this year by means of a credit, as computed above, and having the Treasury Department prepay the credit by issuing "advance refund" checks before October 1 of this year to all eligible taxpayers who timely filed their 2000 tax returns. Therefore, if you filed your federal income tax return for 2000 by this year's April 16 deadline, you may be entitled to an "advance refund" check from the federal government. Taxpayers filing their 2000 income tax return after this year's April 16 deadline, even if they have valid extensions, will receive their checks later in the fall. No checks are to be issued, however, after December 31 of this year (or earlier, if the Treasury decides on an earlier cut-off date for administrative reasons). The Treasury Department will determine who is entitled to an "advance refund" and the amount based on each taxpayer's 2000 income tax return information. Next year, when preparing their 2001 returns, taxpayers will need to reconcile the amount of the credit, based on their actual 2001 tax information, with the amount of the "advance refund" they received this year. In all likelihood, these amounts will simply cancel each other out. However, taxpayers whose actual credit exceeds the amount of the advance refund check they received will simply need to reduce the credit to be claimed on the 2001 return by the amount of the check. Taxpayers who are entitled to the credit but who did not receive an advance refund check will simply claim the full amount of the credit on their 2001 return. What's more, taxpayers whose actual credit turns out to be less than the amount of the check will not be required to repay the credit or include it in taxable income. The lawmakers' rationale for using this "advance refund" method was to provide a more immediate stimulus to the economy than other methods. The following is an overview of the advance refund and a schedule of when payments will be mailed.
Phased-in Individual Income Tax Rate Cuts Besides creating the new 10% bracket, Congress mandated rate reductions in other tax brackets, beginning after June 30, 2001, except for the 15% bracket. The wage withholding tables will be revised accordingly.
The initial reduction will be one percentage point. Thus, the 39.6% rate will be reduced to 38.6%, the 36% rate to 35%, the 31% rate to 30%, and the 28% rate to 27%. Further reductions are to occur in succeeding years. Finally, in 2006, the tax brackets are to be 10%, 15%, 25%, 28%, 33%, and 35%. Alternative Minimum Tax (AM1] Relief for Individuals The legislation provides temporary, but immediate, relief from the individual alternative minimum tax (AMT) by increasing the exemption to $49,000 for joint filers (a $4,000 increase), $24,500 for married taxpayers filing separately (a $2,000 increase), and $35,750 for other individuals (a $2,000 increase) in 2001 through 2004. Other provisions in this legislation, although not directly affecting the AMT, eliminate its adverse impact on the child tax credit, the adoption credit, and the earned income credit. Tax Benefits Relating to Children The new law covers four broad areas relating to children. Here are the highlights. The legislation retroactively increases the child tax credit for 2001 from $500 per child to $600 per child. The $600 limit is to apply through 2004, then increase in stages until reaching $1,000 in 2010. Adoption Expenses. The legislation permanently extends both the adoption credit and the exclusion for employer-provided adoption assistance, which were scheduled to expire after this year, and increases the maximum amount of each from $5,000 to $10,000. Perhaps more important for many taxpayers, however, is that it raises the income level at which the benefits begin to be phased out to $150,000 (versus $75,000 in 2001). Employer-Provided Child Care Facilities. The legislation creates a new credit of up to $150,000 per year for employers who provide employees with child care facilities or child care resource and referral services. The new credit applies in taxable years beginning after December 31,2001. Dependent Care Credit. The legislation also provides more generous dependent care credit limitations that will increase the maximum credit for many taxpayers, but these provisions do not take effect until 2003. The new law also promises relief from the "marriage penalty," but most affected taxpayers will have to wait until 2005 to benefit. One provision will increase the standard deduction for joint filers by making it twice the amount available to single filers. Another provision will stretch the 15% bracket for joint filers to twice the size for single taxpayers, thus taxing a greater portion of joint filers' income at 15% before subjecting their remaining income to higher rates. These provisions will not begin to take effect, however, until 2005. The standard deduction provision is to be phased in over a five-year period and the 15% bracket increase over a four-year period. A provision that will begin to take effect in 2002 (and be fully phased in after 2007) will increase the earned income credit (EIC) available to joint filers by increasing the earned income phase-out amount. Another provision taking effect in 2002 will simplify the EIC computation. A more targeted "marriage penalty"-related provision, which also takes effect in 2002, increases the income phaseout range to permit more joint filers to qualify for "Education IRAs," discussed below. The new law contains several education-related benefits, most of which will go into effect next year. Here's a brief summary. Education IRAs. Beginning in 2002, the legislation significantly expands and liberalizes the "Education IRA" provisions. Perhaps the most notable change is an expanded definition of tax-free "qualified education expenses," formerly limited to post-secondary education, that includes similar expenses (e.g., tuition) for attending elementary and secondary schools. The new law also:
Qualified Tuition Plans. Also effective in 2002, the legislation contains several provisions liberalizing the rules governing these plans, including a provision that allows funds to be rolled over from one plan to another plan maintained for the same beneficiary. The new law also extends this program, currently restricted to state-sponsored plans, to educational institutions (which may be private institutions) meeting certain requirements. Tax-free distributions from private plans, however, will not be available until 2004. Also, tuition credits or certificates will be available from private plans, but such plans will not be able to receive contributions to a savings account. Employer Provided Educational Assistance. The legislation makes the exclusion, which was scheduled to expire at the end of this year, permanent, and extends the exclusion to graduate level courses beginning after December 31, 2001. Student Loan Interest Deduction. Beginning in 2002, the new law:
Above-the-line Deduction for Qualified Higher Education Expenses. Under this temporary provision, applicable from 2002 through 2005, eligible taxpayers can deduct "qualified tuition and related expenses,'' as defined for purposes of the HOPE credit, without having to itemize or be subject to the "miscellaneous itemized deductions" limitation. The maximum deduction is $3,000 in 2002 and 2003 and is limited to taxpayers having adjusted gross incomes (as specially defined) of up to $65,000, or, for joint filers, $130,000. The new law largely incorporates another piece of legislation, called the "Comprehensive Retirement Security and Pension Reform Act of 2001." Here are some highlights. Increases in IRA Contribution Limits. The legislation increases the contribution limits for IRAs and creates a new "catch-up" rule that raises the contribution limits for people aged 50 and above by an additional $500. The new contribution limits for traditional and Roth IRAs will be $3,000 in 2002 and will gradually increase to $5,000 in 2008, with indexing in $500 increments thereafter. Increased Benefit and Contribution Limits for Qualified Retirement Plans. Effective for years beginning after 2001, the legislation:
Plan Loans to Owners. The new law should benefit the owners of many closely held businesses by generally eliminating the special rules relating to plan loans to S corporation shareholders, partners, and sole proprietors, thus permitting such loans without automatically triggering a violation of the "prohibited transaction" rules. Under present law, an individual may make deductible contributions to an IRA up to the lesser of $2,000 or the individual's compensation if neither the individual nor the individual's spouse is an active participant in an employer-sponsored retirement plan. In the case of a married couple, deductible IRA contributions of up to $2,000 can be made for each spouse (including, for example, a homemaker who does not work outside the home), if the combined compensation of both spouses is at least equal to the contributed amount. If the individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased out for taxpayers with adjusted gross income ("AGI") over certain levels for the taxable year. Individuals with AGI below certain levels may make nondeductible contributions to a Roth IRA. The maximum annual contribution that may be made to a Roth IRA is the lesser of $2,000 or the individual's compensation for the year. The contribution limit is reduced to the extent an individual makes contributions to any other IRA for the same taxable year. As under the rules relating to IRAs generally, a contribution of up to $2,000 for each spouse may be made to a Roth IRA provided the combined compensation of the spouses is at least equal to the contributed amount. The maximum annual contribution that can be made to a Roth IRA is phased out for single individuals with AGI between $95,000 and $110,000, and for joint filers with AGI between $150,000 and $160,000. For taxable years beginning after December 31, 2001, the 2001 Act increases the maximum annual dollar contribution limit for traditional and Roth IRAs from $2,000 to $3,000 in 2002, $4,000 in 2003, and $5,000 in 2004. The limit is indexed in $500 increments in 2005 and thereafter. The current year phaseout rules continue to apply. Additional Catch-up Contributions (IRA) For taxable years beginning after December 31, 2002, the 2001 Act provides that individuals who have attained age 50 may make additional catch-up IRA contributions. The otherwise maximum contribution limit (before application of the AGI phase-out limits) for an individual who has attained age 50 before the end of the taxable year is increased by $500 for 2002 through 2005, and $1,000 for 2006 and thereafter. Deemed IRAs under Employer Plans For taxable years beginning after December 31, 2002, the 2001 Act provides that if an eligible retirement plan permits employees to make voluntary employee contributions to a separate account or annuity that (1) is established under the plan, and (2) meets the requirements applicable to either traditional IRAs or Roth IRAs, then the separate account or annuity is deemed a traditional IRA or a Roth IRA, as applicable, for all purposes of the Internal Revenue Code. For example, the reporting requirements applicable to IRAs apply. Under this provision, the deemed IRA, and contributions thereto, are not subject to the Internal Revenue Code rules pertaining to the eligible retirement plan. In addition, the deemed IRA, and contributions thereto, are not taken into account in applying such rules to any other contributions under the plan. The deemed IRA, and contributions to it, are subject to the exclusive benefit and fiduciary rules of ERISA to the extent otherwise applicable to the plan; however, they are not subject to the ERISA reporting and disclosure, participation, vesting, funding, and enforcement requirements applicable to the eligible retirement plan. An eligible retirement plan for purposes of this provision is a qualified or a governmental § 457 plan. Nonrefundable Credit for IRA Contributions Effective for taxable years beginning after December 31, 2001, and before January 1, 2007, the 2001 Act provides a temporary nonrefundable tax credit for contributions made by eligible taxpayers to a traditional or Roth IRA. The maximum annual contribution eligible for the credit is $2,000. The credit rate depends on the adjusted gross income ("AGI') of the taxpayer. Only joint returns with AGI of $50,000 or less, head of household returns of $37,500 or less, and single returns of $25,000 or less are eligible for the credit. The AGI limits applicable to single taxpayers apply to married taxpayers filing separate returns. The credit is in addition to any deduction or exclusion that would otherwise apply with respect to the contribution. The credit rates based on AGI are as follows:
Rollovers The legislation technically repeals the federal "death taxes," but provides a decade-long phase-in period, several changes to the current rules in the interim, and a "carryover basis" provision that is sure to cause confusion and potentially unpleasant income tax consequences to the beneficiaries of many estates. Moreover, further changes in the rules are almost a certainty. Here are a few key points to keep in mind.
One final aspect of the legislation merits comment. Technically, the changes made by the new law, including the "death tax repeal," will cease to apply after 2010! This highly unusual provision was included to insure technical compliance with the federal budget law. The lawmakers obviously assume that this provision will be eliminated in future legislation. Please feel free to arrange an appointment to discuss any of these changes and their impact on your tax planning strategies. Additional Catch-up Contributions (401(k)) The 2001 Act provides that the otherwise applicable dollar limit on elective deferrals under a §401(k) plan is increased for certain individuals. The catch-up contribution provision does not apply to after-tax employee contributions. The provision applies to individuals who are at least age 50 before the end of the plan year and may not make additional elective deferrals to the plan due to §401(k) plan limitations. The additional amount of elective contributions that may be made by an eligible individual participating in such a plan is the lesser of (1) the applicable dollar amount or (2) the participant's compensation for the year reduced by any other elective deferrals of the participant for the year. The applicable dollar amount under a §401(k) plan is $1,000 for 2002, $2,000 for 2003, $3,000 for 2004, $4,000 for 2005, and $5,000 for 2006 and thereafter. Here is an example illustrating the application of the conference agreement, after the catch-up is fully phased-in: Employee A is a highly compensated employee who is over 50 and who participates in a §401(k) plan sponsored by A's employer. The maximum annual deferral limit (without regard to the catch-up provision) is $15,000. After application of the special nondiscrimination rules applicable to §401(k) plans, the maximum elective deferral A may make for the year is $8,000. Under the 2001 Act provision, A is able to make additional catch-up salary reduction contributions of $5,000. The catch-up provision is effective for taxable years beginning after December 31, 2001. The catch-up provision is effective for taxable years beginning after December 31, 2001. Under the 2001 Act, elective deferral contributions to § 401 (k) plans are not subject to the defined contribution plan deduction limits. Some §401(k) plans subject elective deferrals to the normally applicable defined contribution plan deductions limits. For example, a §401(k) plan may limit elective deferrals to the lesser 15% of compensation or $10,500 (the elective deferral limit in 2001). This type of provision can restrict or limit contributions to the plan for lower-paid participants. It also creates administrative burdens for plan administrators, because the 15% limit often is monitored on a payroll-by-payroll basis. Under the revised provision, all participants are able to contribute amounts up to the generally applicable §401(k) plan limit ($11,000 in 2002) if permitted under the plan, and plan administrators will no longer have to monitor the 15% limit. This provision is effective for plan years beginning after December 31, 2001. Increase in Defined Contribution Plan Contribution Limit Effective for plan years beginning after December 31, 2001, the $35,000 limit on annual additions to defined contribution plans is increased to $40,000. In future years, this amount is indexed in $1,000 increments. The 2001 Act also increases the 25% of compensation limitation to 100% effective for plan years beginning after December 31, 2001. This provision allows lower paid participants to contribute more to § 401 (k) plans, because elective deferrals no longer are subject to the deduction limits as discussed above. Elective deferrals under a §401(k) plan may not be distributable prior to the occurrence of one or more specified events. One such event is an employee's financial hardship. Applicable Treasury regulations provide that a distribution is made on account of hardship only if the distribution is made on account of an immediate and heavy financial need of the employee and is necessary to satisfy the heavy need. The Treasury regulations provide a safe harbor under which a distribution may be deemed necessary to satisfy an immediate and heavy financial need. One requirement of this safe harbor prohibits employees from making elective contributions and employee contributions to the plan and all other plans maintained by the employer for at least 12 months after receipt of the hardship distribution. Effective on the date of enactment, the 2001 Act directs the Secretary of the Treasury to revise the applicable Treasury regulations to reduce from 12 months to six months the period during which an employee must be prohibited from making elective contributions and employee contributions in order for a distribution to be deemed necessary to satisfy an immediate and heavy financial need. The revised regulations are to be effective for years beginning after December 31, 2001. Increased Portability for Participants The 2001 Tax Relief Act provides that eligible rollover distributions from §401(k) plans, §403(b) annuities, and governmental § 457 plans generally can be rolled over to any of such plans or arrangements. Similarly, distributions from an IRA generally can be rolled over into a §401(k) plan. This provision does not require qualified plans, §403(b) annuities, and §457 plans to accept rollovers, however. The legislation also provides that employee after-tax contributions may be rolled over into §401(k) plans. In the case of a rollover from another qualified plan, the rollover is permitted only through a direct rollover. In addition, a qualified plan is not permitted to accept rollovers of after-tax contributions unless the plan provides separate accounting for such contributions (and earnings thereon). These provisions are effective for distributions occurring after December 31, 2001. The 2001 Act makes a direct rollover the default option for involuntary distributions that exceed $1,000 and that are eligible rollover distributions from §401 (k) plans. The distribution must be rolled over automatically to a designated IRA, unless the participant affirmatively elects to have the distribution transferred to a different IRA or a qualified plan or to receive it directly. The written explanation provided by the plan administrator is required to explain that an automatic direct rollover will be made unless the participant elects otherwise. The plan administrator also is required to notify the participant in writing (as part of the general written explanation or separately) that the distribution may be transferred without cost to another IRA. The legislation amends the fiduciary rules of ERISA so that, in the case of an automatic direct rollover, the participant is treated as exercising control over the assets in the IRA upon the earlier of (1) the roll-over of any portion of the assets to another IRA, or (2) one year after the automatic rollover. The provision applies to distributions that occur after the Department of Labor has adopted final regulations implementing the Senate amendment. The legislation directs the Secretary of Labor to adopt final regulations implementing this provision no later than three years after the date of enactment. Elimination of Multiple Use Test Generally, the average rate of elective contributions under a § 401 (k)plan on behalf of highly compensated employees may not exceed 125% of the average rate of elective contributions on behalf of nonhighly compensated employees. However, the Code provides an "alternative limitation" that permits the average rate of elective contributions on behalf of highly compensated employees to exceed this limit, provided that the average rate for highly compensated employees is not greater than 2 percentage points more than the average rate for nonhighly compensated employees and is not greater than 200% of that of the average rate for nonhighly compensated employees. A similar nondiscrimination rule tests matching and after-tax employee contributions. The Treasury regulations contain rules that prevent multiple use of the alternative limitation with respect to any highly compensated employee. Accordingly, while the alternative limitation may be used to satisfy either the nondiscrimination test for elective contributions or the nondiscrimination test for matching and employee after-tax contributions, the alternative limitation is not available to satisfy both tests. A special "multiple use test" is prescribed in the regulations to apply in this situation. Effective for plan years beginning after December 31, 2001, the 2001 Act repeals the multiple use test. The Conference Report to the legislation indicates that Congress felt the multiple use test unnecessarily complicates §401(k) plan administration. Elimination of "Same Desk Rule" Elective deferrals under a § 401 (k) plan may not be distributable prior to the occurrence of one or more specified events. These distributable events include "separation from service." A separation from service occurs only upon a participant's death, retirement, resignation, or discharge, and not when the employee continues on the same job for a different employer as a result of the liquidation, merger, consolidation, or other similar corporate transaction. A severance from employment occurs when a participant ceases to be employed by the employer that maintains the plan. Under the so-called "same desk rule," a participant's severance from employment does not necessarily result in a separation from service. In addition to separation from service and other events, a § 401 (k) plan that is maintained by a corporation may permit distributions to certain employees who experience a severance from employment with the corporation that maintains the plan but do not experience a separation from service because they continue on the same job for a different employer. The 2001 Act modifies the distribution restrictions applicable to §401(k) plans to provide that distribution may occur upon severance from employment rather than separation from service. In addition, the provisions for distribution from a §401(k) plan based upon a corporation's disposition of its assets or a subsidiary are repealed. The provisions are effective for distributions after December 31, 2001. Cashout Limit Applied Without Regard to Rollover Contributions Under current law, if a § 401 (k) plan participant ceases to be employed by the employer that maintains the plan, the plan may distribute the participant's nonforfeitable accrued benefit without the consent of the participant and, if applicable, the participant's spouse, if the present value of the benefit does not exceed $5,000. The 2001 Act allows a §401 (k) plan to provide that the present value of a participant's nonforfeitable accrued benefit is determined without regard to the portion of such benefit that is attributable to rollover contributions (and any earnings allocable thereto). The provision is effective for distributions after December 31,2001. Faster Vesting for Employer Matching Contributions The 2001 Act applies faster vesting schedules to employer matching contributions. Under the legislation, employer matching contributions are required to vest at least as rapidly as under one of the following two alternative minimum vesting schedules. A plan satisfies the first schedule if a participant acquires a nonforfeitable right to 100% of employer matching contributions upon the completion of three years of service. A plan satisfies the second schedule if a participant has a nonforfeitable right to 20% of employer matching contributions for each year of service beginning with the participant's second year of service and ending with 100% after six years of service. The provision is generally effective for contributions for plan years beginning after December 31,2001. Option to Treat Elective Deferrals as After-Tax Contributions The 2001 Act provides that a §401(k) plan is permitted to include a "Roth contribution program" that permits a participant to elect to have all or a portion of the participant's elective deferrals under the plan treated as designated Roth contributions. Designated Roth contributions are elective deferrals that the participant designates (at such time and in such manner as the Secretary may prescribe) as not excludable from the participant's gross income. The annual dollar limitation on a participant's designated Roth is the annual limitation on elective deferrals, reduced by the participant's elective deferrals that the participant does not designate as Roth contributions. The plan is required to establish a separate account, and maintain separate recordkeeping, for a participant's designated Roth contributions (and earnings allocable thereto). A qualified distribution from a participant's designated Roth contributions account is not includible in the participant's gross income. A participant is permitted to roll over a distribution from a designated Roth contributions account only to another designated Roth contributions account or a Roth IRA of the participant. The provision is effective for taxable years beginning after December 31, 2005. As illustrated in this letter, the 2001 Tax Relief Act made significant changes to the rules governing §401 (k) plans. The new law will impact administration of these plans for plan years beginning after December 31,2001. After you have had a chance to read this letter, please call me to set up an appointment to further discuss these changes and their effect on your plan. Defined Contribution Plan Limits Under current law, annual additions to defined contribution plans are limited to the lesser of (1) 25% of compensation, or (2) $35,000 (for 2001). Annual additions are the sum of employer contributions, employee contributions, and forfeitures with respect to an individual under all defined contribution plans of the same employer. The $35,000 limit is increased in $5,000 increments. Effective for plan years beginning after December 31, 2001, the $35,000 limit on annual additions is increased to $40,000. In future years, this amount is indexed in $1,000 increments. The 2001 Act also increases the 25% of compensation limitation to 100% effective for plan years beginning after December 31, 2001. Under current law, the maximum annual benefit payable at retirement is generally the lesser of (1) 100% of average compensation or (2) $140,000 (for 2001). The dollar limit is adjusted in $5,000 increments. Also, currently, the dollar limit is reduced if benefits under the plan begin before the Social Security retirement age (currently age 65) and increased for benefits beginning after normal retirement age. Effective for plan years beginning after December 31, 2001, the 2001 Tax Relief Act increases the $140,000 annual benefit limit under a defined benefit plan to $160,000. The dollar limit is reduced for benefit commencement before age 62 and increased for benefit commencement after age 65. Under present law, the annual compensation of each participant that may be taken into account for purposes of determining contributions and benefits under a plan, applying the deduction rules, and for nondiscrimination testing purposes is limited to $170,000 (for 2001). The compensation limit is indexed for cost-of-living adjustments in $10,000 increments. In general, contributions to qualified plans are based on compensation. For a self-employed individual, compensation generally means net earnings subject to self-employment taxes ("SECA taxes"). Members of certain religious faiths may elect to be exempt from SECA taxes on religious grounds. Because the net earnings of such individuals are not subject to SECA taxes, these individuals are considered to have no compensation on which to base contributions to a retirement plan. Effective for plan years beginning after December 31, 2001, the 2001 Act increases to $200,000 the limit on compensation that may be taken into account under a plan. This amount is indexed in $5,000 increments. The definition of compensation for purposes of all qualified plans is amended to include an individual's net earnings that would be subject to SECA taxes but for the fact that the individual is covered by a religious exemption. Under present law, the maximum annual amount of elective deferrals that an individual may make to a §401(k) plan, §403(b) annuity, or a salary reduction simplified employee pension plan is $10,500 (for 2001). The maximum annual amount of elective deferrals that an individual may make to a SIMPLE plan is $6,500 (for 2001). These limits are indexed for inflation in $500 increments. The 2001 Act increases the dollar limit on annual elective deferrals under § 401 (k) plans, § 403 (b) annuities and salary reduction SEPs to $11,000 in 2002. In 2003 and thereafter, the limits are increased in $1,000 annual increments until the limits reach $15,000 in 2006, with indexing in $500 increments thereafter. The Act increases the maximum annual elective deferrals that may be made to a SIMPLE plan to $7,000 in 2002. In 2003 and thereafter, the SIMPLE plan deferral limit is increased in $1,000 annual increments until the limit reaches $10,000 in 2005. Beginning after 2005, the $10,000 dollar limit is indexed in $500 increments. |
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