Certified Public Accountants & Consultants

New Tax Law Changes Under:
"The Economic Growth and Tax Relief Reconciliation Act of 2001"

On June 7, 2001 President Bush signed into law H.R. 1836, The Eonomic Growth and Tax Relief Reconciliation Act of 2001. This new law provides for $1.35 trillion in tax reductions over the next 10 years. The following is a general overview followed by a more in-depth analysis of some of the most significant aspects of the new tax cut legislation, as well as, some perspective on how it could affect your personal and business tax planning. The focus is on provisions going into effect immediately or in 2002. However, a key feature of this law is that many provisions are not slated to become fully effective for several years. Hence, we will touch upon these items to give you a clearer view of the planning horizon.

The new law, officially named the Economic Growth and Tax Relief Reconciliation Act of 2001, provides the largest tax cut since 1981, mainly in the form of tax benefits for individuals. The lion's share of these benefits is derived from income tax rate reductions, an increase in the child tax credit, and the gradual repeal of the federal death taxes.

Another significant part of the legislation offers greater retirement savings incentives, including increases in the contribution limits to individual retirement accounts (IRAs) and employer-sponsored retirement programs such as 401(k) plans. The new law also includes several education-related tax benefits and individual alternative minimum tax (AMT) relief.

Before discussing these provisions, however, we want to explain why you may receive an advance refund check later this year.

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.

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 (AMT) 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.

Child Tax Credit. 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.

Marriage Penalty Relief

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.

Education Provisions

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:

Increases the annual contribution limit to $2,000 per beneficiary (from $500); and

Increases the phaseout range for joint filers to twice the amount for singles, thus making the phaseout range $190,000 to $220,000 of modified adjusted gross income.

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:

Increases the income phase-out range for eligibility, currently set at $40,000 to $55,000 of modified adjusted gross income for single filers and $60,000 to $75,000 for joint filers. The new phase-out ranges will be $50,000 to $65,000 (single filers) and $100,000 to $130,000 (joint filers), with inflation adjustments after 2002; and

Eliminates the rule that limits the deduction to interest paid during the first 60 months in which interest is required.

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.

Retirement Savings Provisions

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:

Increases the limit on annual compensation that may be taken into account for determining, among other things, contributions and benefits under a qualified plan, to $200,000 (from $170,000), with indexing in $5,000 increments thereafter;

Increases the limit on annual additions to a defined contribution plan to $40,000 (from $35,000), with indexing in $1,000 increments thereafter;

Increases the limit on annual benefits that may be received under a defined benefit plan to $160,000 (from $140,000), with inflation adjustments thereafter in $5,000 increments, as under current law;

Increases the dollar limit on elective deferrals under section 401(k) plans, tax-sheltered annuities ( section 403(b) annuities ), and salary reduction simplified employee pension plans ( SEPs ) to $11,000 (from $10,500). The limit is to increase in $1,000 increments in later years until it reaches $15,000 in 2006, with indexing in $500 increments thereafter;

Increases the dollar limit on annual deferrals under section 457 plans, i.e., deferred compensation plans of state or local governments or tax-exempt organizations, to $11,000 (from $8,500). The limit is to increase in $1,000 increments in later years until it reaches $15,000 in 2006, with indexing in $500 increments thereafter;

Increases the dollar limit on annual elective deferrals to a SIMPLE plan to $7,000 (from $6,500). The limit is to increase in $1,000 increments in later years until it reaches $10,000 in 2005, with indexing in $500 increments thereafter.

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.

Death Tax Repeal

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.

The repeal applies to the federal estate and generation-skipping taxes. It does not repeal the federal gift tax. Also, the legislation does not eliminate any state death taxes ;

Complete repeal will not occur until 2010;

Death tax repeal may eliminate the income tax savings achieved through a step up in the basis of property received from a decedent. As a result, families may not be able to take advantage of the potential benefits of death tax repeal without careful planning.

Sunset in 2011?

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.

(In-Depth) 2001 Tax Relief Act Provision Affecting Pension Contribution and Benefit Limits

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.

Defined Benefit Plan Limits

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.

Compensation Limits

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.

Elective Deferral Limit

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.

Deduction Limit for Profit Sharing and Stock Bonus Plans

Under current law, in case of a profit-sharing or stock bonus plan, the employer generally may deduct an amount equal to 15% of compensation of the employees covered by the plan for the year. For purposes of the deduction limits, employee elective deferral contributions to a §401(k) plan are treated as employer contributions and, thus, are subject to the generally applicable deduction limits. However, these amounts are not treated as compensation for purposes of the deduction limits.

Effective for plan years beginning after December 31, 2001, the definition of compensation for purposes of the deduction rules includes employee elective deferrals. In addition, the annual limitation on the amount of deductible contributions to a profit-sharing or stock bonus plan is increased from 15% to 25% of compensation of the employees covered by the plan for the year. Finally, the 2001 Act provides that elective deferrals are not subject to the deduction limits and the application of a deduction limitation to any other employer contribution to a qualified retirement plan does not take into account elective deferral contributions.

As you can see, the 2001 Tax Relief Act made significant changes to the contribution and benefit limitations for qualified plans. The new law will impact plan administration for plan years beginning after December 31, 2001.

(In-Depth) Effect of 2001 Tax Relief Act on IRAs

The legislation makes several changes to the rules governing Individual Retirement Arrangements ( IRAs )

IRA Contribution Limit

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 phase-out rules continue to apply.

Additional Catch-up Contributions

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.

Rollovers

Effective for distributions occurring after December 31, 2001, the 2001 Act provides that distributions from an IRA generally can be rolled over into a qualified plan, §403(b) annuity, or §457 plan. This provision does not require qualified plans, §403(b) annuities, and §457 plans to accept rollovers, however.

The Act also provides that employee after-tax contributions may be rolled over into a traditional IRA.

(In-Depth) Tax Relief Act Provision Impacting §401(k) Plans

The legislation makes significant changes to rules affecting the operation and administration of §401(k) plans.

Elective Deferral Limits

The 2001 Act increases the dollar limit on annual elective deferrals under §401(k) plans 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.

Additional Catch-up Contributions

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.

Deduction Limits

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.

Hardship Withdrawals

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.

Default Rollovers

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 rollover 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.

Along with revising individual tax rates and repealing the estate tax, the Act added new §222, which provides taxpayers with an above-the-line deduction for qualified higher education expenses. The Act also made changes to many of the education incentives already in place. These changes are discussed below.

(In-Depth) Deduction for Higher Education Expenses

The Act provides taxpayers with an above-the-line deduction for qualified higher education expenses paid by the taxpayer during tax years from 2002 through 2005. Qualified education expenses are defined in the same manner as for the HOPE credit under §25A.

In 2002 and 2003, a taxpayer with an adjusted gross income of not more than $65,000 ($130,000 for a married couple filing jointly) is entitled to a maximum annual deduction of $3,000. In 2004 and 2005, the maximum annual deduction rises to $4,000 and taxpayers with higher incomes that do not exceed $80,000 ($160,000 for married couples filing jointly) may deduct a maximum of $2,000 per year. Taxpayers with incomes above these limits receive no deduction and the deduction expires for tax years beginning after 2005.

A taxpayer may not claim the §222 deduction and a HOPE or Lifetime Learning Credit in the same year for the same student. A taxpayer may not claim a deduction for amounts taken into account in determining the amount excludible due to a distribution from an education IRA or the amount of interest excludible for education savings bonds. There is no deduction for the amount of a qualified tuition plan distribution that is excludible from income; however, a taxpayer may claim a deduction for the amount of a distribution from a qualified plan if the distribution is not attributable to earnings.

Modification to Education Individual Retirement Accounts

The Act increases the annual limit on contributions to an education individual retirement account (IRA) from $500 to $2,000. The Conference Agreement also expands the definition of qualified education expenses that may be paid tax-free from an education IRA to include "qualified elementary and secondary school expenses," meaning expenses for (1) tuition, fees, academic tutoring, special need services, books, supplies, computer equipment (including related software and services), and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under state law, (2) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary, and (3) the purchase of any computer technology or equipment or internet access (expenses for computer software not predominately educational in nature (software designed for sports, games, or hobbies) excluded) if these are to be used by the beneficiary or the beneficiary's family during any of the years that the beneficiary is in school.

The Act increases the phase-out range for contributions for married taxpayers filing a joint return so that it is twice the range for single taxpayers. Thus, the phase-out range for married taxpayers filing a joint return is $190,000 to $220,000 of modified adjusted gross income. Moreover, the Act provides that various age limitations do not apply to special needs beneficiaries.

The Act clarifies that corporations and other entities (including tax-exempt organizations) are permitted to make contributions to education IRAs, regardless of the income of the corporation or entity during the year of the contribution. Under the Act, individual contributors to education IRAs are deemed to have made a contribution on the last day of the preceding taxable year if the contribution is made on account of such taxable year and is made not later than the time prescribed by law for filing the individual's federal income tax return for such taxable year (not including extensions). Thus, individual contributors generally may make contributions for a year until April 15 of the following year.

The Act allows a taxpayer to claim a HOPE credit or Lifetime Learning credit for a taxable year and to exclude from gross income amounts distributed (both the contributions and the earnings portions) from an education IRA on behalf of the same student as long as the distribution is not used for the same educational expenses for which a credit was claimed.

For taxable years beginning after 2001, the Act repeals the excise tax on contributions made by any person to an education IRA on behalf of a beneficiary during any taxable year in which any contributions are made by anyone to a qualified State tuition program on behalf of the same beneficiary.

Modifications to Qualified Tuition Programs

The Act expands the definition of "qualified tuition program" to include certain prepaid tuition programs established and maintained by one or more eligible educational institutions (which may be private institutions) that satisfy the requirements under §529 (other than the present-law state sponsorship rule). In the case of a qualified tuition program maintained by one or more private eligible educational institutions, persons are able to purchase tuition credits or certificates on behalf of a designated beneficiary, but would not be able to make contributions to a savings account plan.

The Act provides an exclusion from gross income for distributions made in taxable years from qualified state tuition programs to the extent that the distribution is used to pay for qualified higher education expenses. The Act also allows a taxpayer to claim a HOPE credit or Lifetime Learning credit for a taxable year and to exclude from gross income amounts distributed (both the principal and the earnings portions) from a qualified tuition program on behalf of the same student as long as the distribution is not used for the same expenses for which a credit was claimed.

The Act provides that a transfer of credits (or other amounts) from one qualified tuition program for the benefit of a designated beneficiary to another qualified tuition program for the benefit of the same beneficiary is not considered a distribution. This rollover treatment applies to a maximum of three such transfers with respect to the same designated beneficiary.

The Act eliminates the present-law penalty on distributions not used for higher education expenses and instead applies the same additional tax that applies to educational IRAs. The Act provides that assets of qualified tuition plans of private institutions must be held in trust.

These changes to qualified tuition programs are effective for taxable years beginning after 2001, except that the exclusion from gross income for certain distributions from a qualified tuition program established and maintained by an entity other than a state (or agency or instrumentality thereof) is effective for taxable years beginning after 2003.

Extension of Exclusion for Employer Provided Educational Assistance

The Act extends the §127 exclusion for employer-provided education assistance to graduate education. Further, the Act makes the exclusion permanent as it applies to both graduate and undergraduate education, with the provision effective for courses beginning after 2001.

Modifications to Student Loan Interest Deduction

The Act increases the income phase-out ranges for eligibility for the §221 student loan interest deduction to $50,000 to $65,000 for single taxpayers and to $100,000 to $130,000 for married taxpayers filing joint returns. These income phase-out ranges are adjusted annually for inflation after 2002. Moreover, the Act repeals both the limit on the number of months during which interest paid on a qualified education loan is deductible and the restriction that voluntary payments of interest are not deductible. The repeal is effective for interest paid on qualified education loans after 2001.

Exclusion of Amounts Received Under Certain Scholarship and Financial Assistance Programs

The Act amends §117 to provide that amounts received by an individual under the National Health Service Corps Scholarship Program and the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance Program are eligible for tax-free treatment as qualified scholarships under §117. Unlike the general treatment of scholarships under §117, however, this exclusion is available whether or not the recipient has any service obligation for receiving the scholarship. As with other qualified scholarships under §117, this exclusion does not apply to amounts received by students for regular living expenses, including room and board. This provision is effective for education awards received after 2001.

(In-Depth) 2001 Tax Relief Act Provisions Affecting Adoption, Dependent Care, and Child Tax Credits

Adoption Credit

The Act increased and permanently extended the tax benefits available to taxpayers adopting children. The benefits are in the form of both a credit and an income exclusion, with slightly different rules applying if the adopted child qualifies as a special needs child. Beginning with the 2002 tax year, the aggregate amount of qualified adoption expenses that may be credited is increased to $10,000 (from $5,000 for nonspecial needs and $6,000 for special needs children). At the same time, the exclusion amount of qualified adoption expenses paid by an employer under an adoption assistance program is increased to $10,000, allowing a total credit/exclusion amount of $20,000 if the qualified adoption expenses are not duplicated.

More taxpayers will benefit under the provisions because of an increased income limitation. Previously, the amount of the credit/income exclusion was phased-out ratably for taxpayers with a modified adjusted gross income between $75,000 and $115,000. The new income phase-out range is increased to $150,000 to $190,000 (adjusted for inflation after 2002). The credit, however, will continue to be allowed only to the extent that the taxpayer's regular income tax liability exceeds the taxpayer's tentative minimum tax.

Beginning with the 2003 tax year, the qualified adoption expenses do not have to be substantiated if the taxpayer is adopting a special needs child. The $10,000 credit allowed for the adoption of a child with special needs, however, is allowed for the taxable year in which the adoption becomes final (effective in 2002). A taxpayer finalizing the adoption of a special needs child in 2002 would still be eligible for the $10,000 credit to the extent the taxpayer can substantiate qualified adoption expenses paid or incurred. Unfortunately, such a taxpayer incurring or paying qualified adoption expenses in 2002 and 2003 for an adoption finalized in 2004 will not be allowed the credit until 2004, whereas taxpayers incurring or paying similar qualified adoption expenses for nonspecial needs children would be able to credit the 2002 expenses in the 2003 taxable year.

Dependent Care Credit

The Act increased and expanded the dependent care tax credit. Beginning with the 2003 tax year, the percentage of employment-related expenses that may be credited is increased from 30% to 35%. The dollar limit on employment-related expenses is also increased: from $2,400 to $3,000 (if there is one qualifying dependent) or from $4,800 to $6,000 (if there are two or more qualifying dependents). Phase-down ranges were also changed. The 35% is reduced (but not below 20%) by one percentage point for each $2,000 (or fraction of $2,000) by which the taxpayer's adjusted gross income exceeds $15,000 (with the phase-down previously beginning at $10,000).

Child Tax Credit

The Act increased and expanded the child tax credit. Beginning with the 2001 tax year, the maximum credit amount is increased from $500 to $600, with the amount further increased to: $700 (2005); $800 (2009); and $1,000 (2010). The Act also provided for greater refundability of the credit. For the 2001-2004 calendar years, the credit is now refundable, regardless of the number of children within the taxpayer's family, to the extent of 10% of the taxpayer's earned income in excess of $10,000. The percentage increases to 15% in 2005 and the $10,000 amount is indexed for inflation beginning in 2002. For families with three or more children, a refundable credit is allowed to the extent the taxpayer's social security taxes exceed the taxpayer's earned income credit if the amount exceeds what would otherwise be refundable under the 10%/$10,000 rule.

The Act further benefited taxpayers by providing that the refundable portion of the credit is not income to the taxpayer and cannot be treated as resources in determining eligibility or the amount or nature of benefits under federal or federally funded programs. Finally, beginning in 2002, the credit is allowed to the full extent of both the taxpayer's regular income tax and alternative minimum income tax, with the alternative minimum tax amount no longer reducing the refundable child tax credit.

(In-Depth) The Estate Tax Repeal in the 2001 Tax Relief Act

Estate Tax Repeal

The 2001 Act repeals the estate tax, but repeal will not be effective until January 1, 2010. Although the proponents of repeal had hoped for more immediate action, budgetary constraints delayed outright repeal for more than eight years. Budget rules also required that the Act provide for the reinstatement of the estate tax starting in 2011. It is unlikely, however, that a reinstatement of the tax will take place if repeal actually occurs.

Although repeal lies well in the future, the 2001 Act reduces the estate tax on the estates of those who die during the transitional period. It does this in two ways. First, in a provision that benefits all estates, it steadily increases the individual exemption amount (set at $675,000 for 2001) so that it will be $1.0 million in 2002 and 2003, $1.5 million in 2004 and 2005, $2.0 million in 2006, 2007, and 2008, and $3.5 million in 2009, the final year before repeal. Married couples, with effective planning, are able to take advantage of two exemptions in their estates. Thus, as early as 2002, a couple with a $2.0 million estate will no longer be subject to the estate tax.

The other tax-saving feature during the transitional period is a reduction in the top estate and gift tax rates, currently 55% and 53%. This change will help only wealthier taxpayers, since these top rates affect only estates of more than $2.5 million. Effective January 1, 2002, the top rates of 53% and 55% are eliminated and replaced with a rate of 50% on taxable estates in excess of $2.5 million. The top rate is then further reduced by 1% a year until 2007, when it will be 45%, and it remains at that level until the tax is repealed at the end of 2009.

Generation-Skipping Transfer Tax Repeal

The Act also repeals the generation-skipping transfer (GST) tax, effective for transfers after December 31, 2009. This tax is imposed on gifts and bequests to grandchildren and more distant generations, and to trusts established for their benefit. Currently, planning for the GST tax is focused on the effective use of the $1.0 million GST exemption. This exemption is scheduled to increase in tandem with the estate tax exemption, so that the GST exemption will be $3.5 million in 2009, the year before repeal. If your estate plan includes a generation-skipping trust, we should reexamine it in light of this increased exemption.

There will also be a reduction in the current GST tax rate of 55% during the transition period, since that rate is linked to the highest estate tax rate, which will fall to 45% by 2007.

Retention of the Gift Tax

To the surprise of many, the 2001 Act did not repeal the gift tax. Even after estate tax repeal, the gift tax will continue to be imposed on gifts in excess of the individual exemption amount. Congress was less than generous in setting the lifetime exemption amount for gift tax purposes. Like the estate tax exemption, the gift tax exemption increases to $1.0 million in 2002, but receives no further increases. Thus, it will indefinitely remain at $1.0 million.

In 2010 the maximum gift tax rate will drop to 35%, equal to the top income tax rate for individuals. There is good reason for this linking of the top gift tax and income tax rates. Congress decided to retain the gift tax due to concerns that lack of a gift tax would encourage taxpayers to make tax-free gifts of income-producing property to family members in lower income tax brackets. Such transfers would be an easy way to reduce the overall income tax burden on the family. Although it will still be possible to make such transfers after estate tax repeal, the reduced gift tax will act as a toll charge for taxpayers engaging in this type of planning.

Repeal of Family-Owned Business Deduction

The Act repeals the family-owned business deduction, effective for persons dying after December 31, 2003. At first glance, this repeal seems not in keeping with Congress' goal of reducing estate taxes. However, the amount of the family-owned business deduction, when combined with the exemption amount, is limited to $1.3 million. Since the exemption amount increases to $1.5 million in 2004, the allowable deduction would have decreased to zero. As a result, Congress concluded that there was no longer a need for the deduction. Given the complex requirements for qualifying for the deduction, this is a good result for taxpayers.

Repeal of State Death Tax Credit

Under current law, an estate is entitled to a dollar-for-dollar federal estate tax credit (subject to a cap) for any state death taxes paid by the estate. This credit was repealed by the Act, effective for those dying after 2004, and replaced with a state death tax deduction.

The repeal of the state death tax credit will have no immediate effect on most estates, since most state death taxes are written in such a way that they apply only if they qualify for the federal credit. The repeal of the federal credit will effectively repeal these state taxes. But do not be surprised if some states revise their laws to reimpose their estate taxes even if the credit is no longer available.

Loss of Basis Step-Up at Death

The quid pro quo for repeal of the estate tax was the loss of step-up in income tax basis at death. Currently, most property owned by a decedent for estate tax purposes receives a date-of-death basis for income tax purposes, unless the alternate valuation date (six months after death) is elected on the estate tax return. Effective for persons dying after December 31, 2009, property acquired from a decedent will retain the decedent's tax basis. This is known as carryover basis. When the recipient of the property eventually sells it, he or she will be compelled to compute the gain using the decedent's adjusted basis. In most cases, the decedent's basis will be less than the date-of-death value, resulting in an increased capital gains tax.

The legislation contains two major exceptions to carryover basis. First, the estate of every decedent who is a U.S. citizen or resident will be entitled to increase the basis of the decedent's property by up to $1.3 million ($60,000 for estates of nonresident aliens), although no item of property may have its basis increased above its fair market value on the date of death. If the estate is valued at $1.3 million or less, each asset will automatically receive a basis equal to its date-of-death value. If the estate is larger than $1.3 million ($60,000 for estates of nonresident aliens), the estate must file a return allocating the basis increase to specific assets.

If the decedent was married, the estate is entitled to an additional basis increase of up to $3.0 million for property passing to the surviving spouse, regardless of citizenship or residence. This increase can be applied to property passing outright to the spouse or in the form of a QTIP trust. It will also be necessary to file a return to claim the $3.0 million basis increase and to allocate it to the marital property.

Both the $1.3 million and $3.0 million basis increases (as well as the $60,000 for nonresident aliens) will be subject to an annual inflation adjustment after 2010.

Planning Considerations During the Transition Period

Because the estate tax remains in effect until the end of 2009, it is not recommended that you immediately revise your estate plan to take advantage of its repeal. Since we all have a chance of dying before repeal takes place, it is necessary to have an estate plan that is designed to minimize the estate tax. Estate tax repeal will do little good for the individual who dies on or before December 31, 2009, when the tax is still in effect.

Because of the phased-in increase in the unified credit that takes place during the transitional period, it is important that your current estate plan be reviewed to ensure that it takes advantage of this increase. If your plan uses a formula clause that allocates a portion of your estate to a credit shelter trust that is equal to the amount of the unified credit on the date of death, it will be able to take advantage of the increased credit. If, however, it refers to a specific dollar amount, it needs to be revised if you wish to use the increased credit. In some cases, however, a formula clause may no longer be appropriate. If the value of the combined estates of both spouses is under $4.0 million, a formula clause could have the effect of shifting too much of the estate into the credit shelter trust and leaving too little outright to the surviving spouse.

Planning Considerations After Repeal

It is not too soon to start thinking about how your estate plan will be affected by estate tax repeal. After 2009, the focus of estate planning will shift to income tax planning, and you should consider the effect that this will have on your plan. Because of the loss of stepped-up basis, planning will concentrate on the effective use of the total $5.6 million basis increase that is available to a married couple and the $1.3 million increase that can be used by a single individual.

For a married couple, it is likely that their revised estate plan will include a shelter trust that will hold property with a basis that is $1.3 million less than its date-of-death value. Such a trust, which could benefit both the surviving spouse and the children, would take advantage of the $1.3 million basis increase available to every estate. The second component of the plan would be a bequest to the surviving spouse (either outright or in trust) that would be funded with property that has a basis that is $3.0 million less than its date-of-death value. This bequest would use the $3.0 million basis increase available for transfers to a surviving spouse. When the surviving spouse died, his or her estate will still have its own $1.3 million basis increase that could be allocated where it could do the most good.

Since the gift tax is not being repealed, valuation discounts will remain a valuable tool in making lifetime transfers. Family limited partnerships and limited liability companies will continue to be used to minimize the value of lifetime gifts to family members, thereby maximizing the use of the $1.0 million gift tax exemption. There will, however, be a disincentive to making lifetime gifts in excess of $1.0 million, since such gifts will be subject to a 35% gift tax rate. By waiting to make such gifts until death, the gift tax will be avoided.

Lifetime charitable gift planning is unlikely to change, since much of it is income tax driven. Charitable remainder trusts will still be valuable tools for eliminating the tax on appreciated assets, while at the same time converting those assets into a lifetime income stream. With the loss of the estate tax, there will be less of an economic incentive for making charitable gifts at death, yet some clients may still wish to fulfill their charitable impulses by making such gifts. With the loss of stepped-up basis at death, it will become important to give the executor the ability to satisfy charitable bequests with appreciated property, rather than cash, to get the appreciated property out of the estate.

The role of life insurance in estate planning will change. After estate tax repeal takes effect, it will no longer be necessary to maintain policies solely for the purpose of paying estate tax. It may be advisable to cash in or sell such policies at that time. Likewise, irrevocable life insurance trusts may no longer be appropriate after repeal, since most such trusts are established for the purpose of insulating the proceeds from estate tax. If you have established such a trust, we should reexamine its purposes in light of estate tax repeal.

Conclusion

Congress, in the 2001 Tax Relief Act, finally achieved the goal of estate tax repeal. Repeal does not, however, eliminate the need for effective estate planning, particularly in light of the increased capital gains taxes that will be imposed on property received from an estate. Fortunately, the eight and one-half year transitional period gives us sufficient time to review your current estate plan and, if necessary, modify it to meet the challenges of the new tax regime.

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