ISBN Copyright 2001, The National Underwriter Company P.O. Box Cincinnati, OH

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2 This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. From a Declaration of Principles jointly adopted by a Committee of The American Bar Association and a Committee of Publishers and Associations. ISBN Copyright 2001, 2002 The National Underwriter Company P.O. Box Cincinnati, OH All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without prior written permission of the publisher. Printed in the United States of America ii

3 TABLE OF CONTENTS ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT OF v Sunset Provision... v GENERAL INCOME TAX Rates, Exemptions and Itemized Deductions... 1 Tax Benefits Relating to Children... 6 Alternative Minimum Tax Corporate Income Tax EDUCATION INCENTIVES Education IRAs Qualified Tuition Programs Modifications to Student Loan Interest Deduction New Deduction for Higher Education Expenses RETIREMENT PLAN PROVISIONS IRAs Section 457 Plans Tax Sheltered Annuities Pension and Profit Sharing Plans Rollovers ESTATE PLANNING PROVISIONS Estate Tax Gift Tax Generation-Skipping Transfer (GST) Tax Carryover Basis INDEX iii

4 ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT OF 2001 On June 7, 2001, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001) was enacted. The Act makes significant changes in the following tax areas: general income tax, education incentives, estate planning, and retirement plans. These changes are discussed here. It should be noted that all changes made by the Act sunset, or expire, at the end of [Act Sec. 901.] If Congress were to do nothing else before then, tax law would generally revert to the way it existed prior to the Act. Also, many of the provisions in the Act take effect in future years. Such provisions could be changed or eliminated prior to becoming effective. Nevertheless, financial services professionals must work with the tax law as it exists today, keeping in mind that everything is possibly subject to change. Throughout this publication, you will find citations to the sections of the Act discussed and the sections of the Internal Revenue Code of 1986 affected. You will also find references to questions in the 2001 editions of Tax Facts 1, Tax Facts 2, and ERISA Facts. The questions referenced generally discuss the current tax law and offer background and supporting information. Tax Facts 1 covers the federal income, estate, gift, and generation-skipping transfer taxation of annuities, life insurance, health insurance, IRAs, pension and profit sharing plans (including 401(k) plans), ESOPs, nonqualified deferred compensation plans, Section 403(b) tax sheltered annuities, rollovers, cafeteria plans, VEBAs, and business continuation arrangements. Tax Facts 2 covers the federal income, estate, gift, and generation-skipping transfer taxation of stocks, bonds, mutual funds, puts, calls, and futures, as well as real estate, oil & gas, and other tax shelters. ERISA Facts covers ERISA and Department of Labor regulations and rulings on a wide variety of employee benefit plans, administrative requirements, disclosure provisions, fiduciary duties and liabilities, prohibited transactions, investment issues, civil compliance and enforcement issues, and criminal enforcement. SUNSET PROVISION All provisions of, and amendments made by, this Act are scheduled to sunset, or expire for taxable, plan, or limitations years beginning after December 31, With respect to the estate, gift, and generation-skipping provisions of the Act, the amendments are not scheduled to apply to estates of decedents dying, gifts made, or generation-skipping transfers after December 31, The Internal Revenue Code of 1986 and the Employee Retirement Income Security Act of 1974 will apply to such years, and to estates, gifts, and transfers after December 31, 2010, as if the provisions of, and amendments made by, the Act had never been enacted. v

5 GENERAL INCOME TAX GENERAL INCOME TAX RATES, EXEMPTIONS, AND ITEMIZED DEDUCTIONS Reduction in Individual Income Tax Rates Under current law, there are four income tax rates: 15%, 28%, 31%, and 36%. In addition, a surtax exists in the form of a 39.6% tax rate. The income brackets to which each rate applies depend on the taxpayer s filing status: single; head of household; married filing a joint return; or married filing a separate return. The Act implements sweeping changes in the current regular income tax rate structure for individual taxpayers, including: (a) the creation of a new 10% income tax bracket; and (b) a phased in reduction of the marginal income tax rates applicable to individuals, trust and estates. New 10% Tax Bracket The Act creates a new 10% income tax bracket for a portion of the income that was previously taxed at 15%. For tax years beginning in 2001 through 2007, the new 10% tax rate bracket applies to the first: $12,000 of taxable income for married individuals filing joint returns; $6,000 for unmarried individuals, and married individuals filing separate returns; and, $10,000 for heads of households. For 2008 through 2010, the 10% tax rate bracket applies to the first: $14,000 of taxable income for married individuals filing joint returns; $7,000 for unmarried individuals, and married individuals filing separate returns; and $10,000 for heads of households. Under IRC section 1(i)(1)(C), the new 10% income tax bracket will be indexed for inflation for tax years beginning after December 31, The new 10% income tax rate is technically effective as of January 1, However, the Act provides for an immediate rate reduction credit of 5% (i.e., the difference between the 15% rate and the 10% rate) under new IRC section 6428(a). It was decided that this credit would more immediately achieve one of the purposes behind the new bottom tax rate bracket. The credit mechanism was chosen (along with the issuance of checks, described below) because it was believed it would deliver economic stimulus to the economy more rapidly than would implementation of the new 10% rate bracket (even if that were accompanied by an immediate implementation of new wage withholding tables). Thus, this rate reduction credit operates in lieu of the new 10% income tax bracket for

6 TAX RELIEF 2001 The credit will be computed as 5% of the amount of taxable income that would have been eligible for the new 10% rate. It is important to note that taxpayers may not receive a credit in excess of their income tax liability, determined after nonrefundable credits. Most taxpayers will receive this credit in the form of advance refund checks, which are scheduled to be issued by October 1, For most taxpayers the checks will be issued in the following amounts: Filing Status Check Amount Single/Married Filing Separately $300 Heads of Households $500 Married Filing Jointly $600 An individual who can be claimed as a dependent on another individual s income tax return is not eligible to receive an advance refund check. The conference report states that because the refund checks will be issued on the basis of income tax returns filed for 2000, after receiving their refund checks, taxpayers will need to complete a worksheet calculating the amount of the credit based on their 2001 income tax return. Taxpayers should subtract the calculated credit amount from the check amount. If that number is negative, the taxpayer is not required to repay that amount to the Treasury. If the number is positive, the taxpayer can claim that amount as a credit against 2001 tax liability. [Act Sec IRC Secs. 1, Tax Facts 1 (2001): Q 726. Tax Facts 2 (2001): Q 428.] Lower Income Tax Rates The Act reduces the current regular income tax rates of 28%, 31%, 36% and 39.6% by gradual increments to 25%, 28%, 33%, and 35%, respectively. Starting July 1, 2001, the tax rates are scheduled to fall in increments until the rate reductions are complete in For tax years beginning during 2001, the tax rates will be reduced as follows: 28% to 27.5%; 31% to 30.5%; 36% to 35.5%; and 39.6% to 39.1%. A summary of the scheduled rate reductions for the 28%, 31%, 36%, and 39.6% rate brackets is as follows: Calendar Year 28% 31% 36% 39.6% % 30.5% 35.5% 39.1% % 30% 35% 38.6% % 29% 34% 37.6% % 28% 33% 35% 2

7 GENERAL INCOME TAX When the phasein of the rate changes is completed in 2006, there will ultimately be six income tax brackets: the new 10% bracket (as explained above), 15%, 25%, 28%, 33%, and 35%. The Treasury Secretary is expected to make appropriate revisions to the wage withholding tables to reflect the rate reductions that will be effective beginning July 1, 2001, as expeditiously as possible. The reductions in the tax rates (other than the new 10% rate) are effective after June 30, The tax rates for estates and trusts (currently 28%, 31%, 36%, and 39.6%), will also be reduced according to the reductions schedules shown above. [Act Sec IRC Sec. 1. Tax Facts 1 (2001): Q 726. Tax Facts 2 (2001): Q 428.] Marriage Penalty Relief Elimination of Marriage Penalty in Standard Deduction To calculate taxable income, taxpayers may subtract from their adjusted gross income either (1) the standard deduction or (2) their itemized deductions. The size of the standard deduction varies according to the taxpayer s filing status (e.g., single, married filing jointly, married filing separately, or head of household). In 2001, the standard deduction is $4,550 for unmarried individuals, and $7,600 for married individuals filing jointly. Currently, the tax liability of married taxpayers filing a joint return is usually greater than the sum of their individual tax liabilities computed as if the taxpayers were not married. This is commonly referred to as the marriage penalty. It is attributable to the way in which the standard deduction is structured for married taxpayers who file joint returns. Currently, provisions of IRC section 63(c)(2) result in the basic standard deduction for an individual filing a single return being 60% of the basic standard deduction amount for a married couple filing a joint return. Thus, two unmarried individuals have standard deductions whose sum exceeds the standard deduction for a married couple filing a joint return. Under the Act, the standard deduction for a married couple filing a joint return will be increased until it is twice the basic standard deduction for an unmarried individual filing a single return. The increase will be gradually phased in according to the following schedule: Calendar Year Married filing jointly standard deduction as a percentage of the single standard deduction % % % % % 3

8 TAX RELIEF 2001 This provision is effective for tax years beginning after December 31, [Act. Sec IRC Sec. 63. Tax Facts 1 (2001): Q 715. Tax Facts 2 (2001): Q 427.] Increase in Size of 15% Tax Bracket for Married Taxpayers Filing Joint Returns Currently, the provisions of IRC section 1 result in a bracket breakpoint for the 15% tax rate bracket for single individuals being approximately 60% of the breakpoint for the 15% tax rate bracket for married individuals filing joint returns. For example, prior to the Act, the 15% tax rate bracket as indexed for 2001 applies to taxpayers as shown below: Single Married Filing Jointly $0 $27,050 $0 $45,200 If married couples filing jointly were treated, for this purpose, the same as two single individuals, the 15% bracket would extend to a more favorable ending point of $54,100 instead of $45,200. Consequently, married individuals who file joint returns under current law are subject to having more of their income taxed in the next tax rate bracket (i.e., the 28% bracket) instead of the lower 15% bracket. The Act gradually increases the size of the 15% tax rate bracket for married taxpayers filing a joint return until that rate bracket is twice the size of the 15% bracket for an unmarried individual filing a single return. This increase will be phased in as follows: Calendar Year Applicable Percentage Increase % % % % The provision is effective for taxable years beginning after December 31, [Act Sec IRC Sec. 1. Tax Facts 1 (2001): Q 726. Tax Facts 2 (2001): Q 428.] Repeal of Limitation on Itemized Deductions IRC section 68 currently provides that a taxpayer s aggregate itemized deductions will be reduced dollar-for-dollar upon reaching certain income levels (which are indexed for inflation). For individuals in 2001, the total amount of otherwise allowable itemized deductions (other than medical expenses, investment interest, and casualty, theft, or wagering losses) is reduced by 3% of the amount of the taxpayer s adjusted gross income in excess of $132,950 ($66,475 for married taxpayers filing separately). The Act repeals the overall limitation on itemized deductions by gradually reducing the limitation over a 5-year period, as shown below: 4

9 GENERAL INCOME TAX Calendar Year Applicable Fraction 2006 and % (2/3) 2008 and % (1/3) 2010 Repealed In other words, the amended limitation amount is calculated by multiplying the otherwise applicable limitation amount by the applicable fraction. Example: Assume a married couple with adjusted gross income for 2001 of $182,950 has $10,000 in itemized deductions. Their income exceeds the threshold ($132,950) by $50,000, therefore $1,500 ($50,000 x 3%) is nondeductible in 2001, and they may claim only $8,500 for However, assuming the same numbers in later years (disregarding any inflation adjustments), the same couple would be able to claim $9,000 in itemized deductions in 2006 [$10,000 ($1,500 x 66.6%)], $9,500 in 2008 [$10,000 ($1,500 x 33.3%)], and $10,000 in 2010 and later [$10,000 ($1,500 x 0%)]. This provision is generally effective for tax years beginning after December 31, 2005, with the repeal effective for tax years beginning after December 31, [Act Sec IRC Sec. 68. Tax Facts 1 (2001): Q 719. Tax Facts 2 (2001): Q 423.] Repeal of Personal Exemption Phaseout In 2001, taxpayers are generally permitted to deduct the following personal exemption amounts: $2,900 for married taxpayers filing a joint return (i.e., $5,800 for both); and $2,900 for single individuals, married taxpayers filing separate returns, and heads of households. The personal exemption amount is indexed for inflation. IRC section 151(d)(3) currently provides that the personal exemptions of certain upper income taxpayers are phased out over defined income levels. The total dollar amount of personal exemptions that may be claimed is reduced by 2% for each $2,500 (or fraction thereof; $1,250 for married individuals filing separately) by which the taxpayer s adjusted gross income exceeds the applicable threshold amounts. Once the taxpayer s adjusted gross income reaches the upper limit, the exemption is fully phased out. The threshold amounts and upper limits for 2001 are as follows: Filing Status Threshold /Upper Limit Married Filing Separately $99,725 / $160,975 Single $132,950 / $255,450 Heads of Households $166,200 / $288,700 Married Filing Jointly $199,450 / $321,950 The Act amends this provision by repealing the personal exemption phaseout. The amended phaseout amount is calculated by multiplying the otherwise appli- 5

10 TAX RELIEF 2001 cable phaseout amount by the applicable fraction. The phaseout will be reduced gradually, as follows: Calendar Year Applicable Fraction 2006 and % (2/3) 2008 and % (1/3) 2010 Repealed The amendment is generally effective for tax years beginning after December 31, 2005, with repeal effective for tax years beginning after December 31, [Act. Sec IRC Sec Tax Facts 1 (2001): Q 717. Tax Facts 2 (2001): Q 421.] TAX BENEFITS RELATING TO CHILDREN Child Tax Credit Under IRC section 24, a child tax credit is available for each qualifying child of eligible taxpayers who meet certain income requirements. The basic credit for each qualifying child, subject to limitations, is $500. Increase in Amount of Credit The Act doubles the child tax credit to $1,000. The increase will be phased in over a 10-year period, as follows: Tax Years Beginning in: Credit Amount per Child: 2001, 2002, 2003, and 2004 $ , 2006, 2007, and 2008 $ $ $1,000 Refundability IRC section 24(d) currently provides that the child tax credit is not refundable for taxpayers with two or fewer qualifying children. Thus, a taxpayer with only one or two qualifying children cannot currently receive a refund of any excess credit remaining after his tax liability has been reduced to $0. For taxpayers with three or more qualifying children, the child tax credit is currently refundable up to the amount by which the taxpayer s Social Security taxes exceed the taxpayer s earned income credit under IRC section 24(d). The Act amends IRC section 24(d) to provide that the child tax credit is refundable, regardless of the number of qualifying children, to the extent of 10% of the taxpayer s earned income in excess of $10,000 for calendar years 2001 through The percentage increases to 15% for calendar years 2005 and later. The $10,000 amount will be indexed for inflation beginning in

11 GENERAL INCOME TAX The Act further amends IRC section 24(d) to provide that families with three or more qualifying children are allowed a refundable credit for the amount by which the taxpayer s Social Security taxes exceed the taxpayer s earned income credit if that amount is greater than the refundable credit based on the taxpayer s earned income in excess of $10,000. Effect on Alternative Minimum Tax Ordinarily, the aggregate amount of nonrefundable personal credits (e.g., the $500 child tax credit) allowed in a year may not exceed the amount by which a taxpayer s regular tax liability exceeds the taxpayer s tentative minimum tax (determined without regard to the alternative minimum tax foreign tax credit). However, for tax years beginning in 2001, IRC section 26(a) provides that the nonrefundable personal credits may be used to offset both the taxpayer s regular income tax liability and the taxpayer s alternative minimum tax (i.e., the excess of a taxpayer s tentative minimum tax over his regular tax liability). For tax years beginning after December 31, 2001, nonrefundable personal tax credits, such as the child tax credit, may not reduce an individual s income tax liability below his tentative alternative minimum tax under IRC section 26(a). The Act amends IRC section 24(b) to allow the child tax credit to the extent of the full amount of the regular income tax and alternative minimum tax. Furthermore, the refundable tax credit will no longer be reduced by the amount of the alternative minimum tax under amended IRC section 24(b). These provisions are generally effective for tax years beginning after December 31, The provision allowing the child tax credit to offset the alternative minimum tax is effective for taxable years beginning after December 31, [Act. Sec IRC Sec. 24. Tax Facts 1 (2001): Q 732. Tax Facts 2 (2001): Q 433.] Adoption Tax Benefits Adoption Tax Credit The qualified adoption credit is generally available for individuals who pay qualified adoption expenses in connection with the adoption of an eligible child under IRC section 23(a). Under current law, the amount of the qualified adoption credit must not exceed $5,000 per child for qualified adoption expenses ($6,000 for special needs children). Currently, the qualified adoption credit for special needs children is permanent, but the credit expires with respect to other children after December 31, The Act permanently extends the adoption credit to adoptions of non-special needs children. The Act also increases the maximum credit to $10,000 per eligible child, including special needs and non-special needs children. Furthermore, the Act provides that 7

12 TAX RELIEF 2001 the $10,000 credit can be claimed in the year a special needs adoption is finalized even if the taxpayer does not have any qualified adoption expenses. Under the Act, the adoption credit is phased out ratably for taxpayers with modified adjusted gross income between $150,000 and $190,000 (under prior law, the phaseout range was $75,000 to $115,000). (Modified adjusted gross income is the taxpayer s adjusted gross income without applying IRC section 911, the foreign earned income exclusion or foreign housing exclusion). Finally, the Act also provides that the adoption credit will be allowed to offset the taxpayer s alternative minimum tax permanently. These provisions are generally effective for taxable years beginning after December 31, The provision allowing the adoption credit for special needs adoptions regardless of whether the taxpayer has qualified adoption expenses is effective for tax years beginning after December 31, [Act. Sec IRC Sec. 23. Tax Facts 1 (2001): Q 730. Tax Facts 2 (2001): Q 432.] Exclusion from Income for Payments Received from Employer Adoption Assistance Programs Under current law, IRC section 137(b)(1) provides for a maximum exclusion from income of $5,000 ($6,000 for special needs adoptions) for qualified adoption expenses paid or reimbursed by an employer under an adoption assistance program. IRC section 137(f) currently provides that the exclusion from income does not apply to amounts paid or expenses incurred after December 31, The Act permanently extends the exclusion from income for employer-provided adoption assistance, and raises the maximum exclusion allowance amount to $10,000 for special needs and non-special needs children. In addition, the Act provides a $10,000 exclusion in the case of a special needs adoption regardless of whether the taxpayer has qualified adoption expenses. Furthermore, the Act phases out the exclusion ratably for taxpayers with modified adjusted gross income (defined above) between $150,000 and $190,000 (under prior law, the phaseout range was $75,000 to $115,000). These provisions are generally effective for tax years beginning after December 31, The provision allowing the exclusion from gross income for special needs adoptions regardless of whether the taxpayer has qualified adoption expenses is effective for tax years beginning after December 31, [Act. Sec IRC Sec Tax Facts 1 (2001): Q 702. Tax Facts 2 (2001): Q 404.] Dependent Care Credit A credit is available for certain child and dependent care expenses incurred by a taxpayer for the care of a qualifying individual as a result of the taxpayer s employment. 8

13 GENERAL INCOME TAX Under current law, eligible taxpayers are allowed a credit of up to 30% of certain expenses incurred for the care of a qualifying individual This amount is further reduced by one percentage point for each $2,000 (or fraction thereof) by which the taxpayer s adjusted gross income for the tax year exceeds $10,000. The Act provides that eligible taxpayers will be allowed a credit of up to 35% of certain expenses incurred for the care of a qualifying individual. The Act further provides that the credit will be reduced by one percentage point for each $2,000 by which the taxpayer s adjusted gross income exceeds $15,000. The Act increases the maximum amount of eligible employment-related expenses from $2,400 to $3,000 for one qualifying individual, and from $4,800 to $6,000 for two qualifying individuals. These provisions are effective for tax years beginning after December 31, [Act. Sec IRC Sec. 21. Tax Facts 1 (2001): Q 730. Tax Facts 2 (2001): Q 432.] Tax Credit for Employer Provided Child Care Facilities The Act provides a new tax credit for employers that provide child care facilities for their employees. The amount of the credit is 25% of qualified child care expenditures and 10% of qualified child care resource and referral expenditures. This credit may not exceed $150,000 for any tax year. The term qualified child care expenditure means any amount paid or incurred: (1) to acquire, construct, rehabilitate, or expand property used as part of a qualified child care facility of the taxpayer, which would allow a depreciation deduction, as long as the property is not part of the principal residence of the taxpayer or an employee of the taxpayer; (2) for the operating costs of a qualified child care facility, including costs related to the training of employees, to scholarship programs, and for compensation to employees; or (3) under a contract with a qualified child care facility to provide child care services to employees of the taxpayer. Qualified child care resource and referral expenditures are amounts paid under a contract to provide child care resource and referral services to an employee of the taxpayer. A credit may not be taken for payments made for services that discriminate in favor of highly compensated employees. A qualified child care facility is a facility: (1) the principal use of which is to provide child care assistance; and (2) which meets all the requirements of all state and local laws in which it is located, including the licensing of the facility as a child care facility. Such a facility may not be the principal residence of the operator of the facility. A qualified child care facility also must: (1) have open enrollment for the employees of the taxpayer; (2) not discriminate in favor of highly compensated employees of the taxpayer; and (3) if the facility is the principal trade or business of the taxpayer, have at least 30% of the children enrolled must be dependents of the taxpayer s employees. 9

14 TAX RELIEF 2001 There are recapture rules if the qualified child care facility ceases operation within 10 years of starting up or if there is a change in ownership in the child care facility. (However, special rules may apply if the purchaser agrees to assume the recapture liability.) The recapture amount is the product of credits previously taken and a percentage determined by the following table: If the recapture event occurs in: The applicable recapture percentage is: Years % Year 4 85% Year 5 70% Year 6 55% Year 7 40% Year 8 25% Years 9 and 10 10% Years 11 and thereafter 0% Special rules apply in the case of controlled groups, employers under common control, estates, trusts, and partnerships. If a taxpayer uses this credit with respect to property, the basis of the property is reduced by the amount of the credit. Also, no other deductions or credits may be taken for payments that result in a tax credit. This credit is available for tax years after [Act Sec IRC Sec. 45F. Tax Facts 2 (2001): Q 432.] ALTERNATIVE MINIMUM TAX Temporary Increase in Exemption Amounts The Act increases the exemption amounts for the alternative minimum tax (AMT) for individuals in tax years beginning in 2001, 2002, 2003, and For married taxpayers filing joint returns and surviving spouses the exemption amount increases from $45,000 to $49,000; for married taxpayers filing separate returns the exemption amount increases from $22,500 to $24,500; and for other individual taxpayers the exemption increases from $33,750 to $35,750. The exemption amounts for corporations, trusts, and estates are not changed. For tax years where the increased exemption amounts are in effect, a married taxpayer filing a separate return must increase alternative minimum taxable income (AMTI) by the lesser of (a) 25% of the excess of AMTI over $173,000, or (b) $24,500. For tax years beginning after 2004, the exemption amounts revert to the previous amounts and the rules regarding the increase in AMTI for married individuals filing separately return to pre-2001 rules. [Act Sec IRC Sec. 55. Tax Facts 1 (2001): Q 727. Tax Facts 2 (2001): Q 435.] 10

15 GENERAL INCOME TAX CORPORATE INCOME TAX Reduction of Accumulated Earnings Tax and Personal Holding Company Tax Rates The accumulated earnings tax is a corporate penalty tax designed to prevent corporations from avoiding double taxation by retaining an unreasonable amount of earnings within the corporation. The personal holding company Tax is another penalty tax, which is intended to discourage the use of a corporation to avoid higher personal income tax rates on income from securities and other income producing property. Both of these taxes have tax rates equal to the highest personal rate (previously 39.6%). These rates are reduced as follows: to 39.1% for 2001, 38.6% for 2002 and 2003, 37.6% for 2004 and 2005, and 35% for 2006 and thereafter. [Act Sec. 101(c)(4),101(c)(5). IRC Secs. 531, 541. Tax Facts 1 (2001): Q 736.] Extension of Time to Make Certain Estimated Tax Payments The Act extends the time for corporations to make certain estimated tax payments. The estimated payment that would normally be due on September 17, 2001 is not due until October 1, For estimated payments due on September 15, 2004, 80% is due by September 15, 2004 and 20% is due by October 1, [Act Sec IRC Sec ] 11

16 EDUCATION INCENTIVES EDUCATION INCENTIVES EDUCATION IRAS The Act makes several beneficial changes to Education IRAs, all of which are effective for taxable years beginning after December 31, [Act Sec. 401(h). IRC Sec Tax Facts 1 (2001): Q 248.] Contributions The Act increases the limit on maximum annual contributions to an Education IRA on behalf of a beneficiary from $500 to $2,000 for a taxable year. Also, in an effort to remove any marriage penalty, the Act raises the beginning of the phaseout for married individuals filing a joint return and lengthens the phaseout range. Thus, the phaseout for married individuals filing a joint return does not begin until $190,000 and the limit is not reduced to $0 until $220,000 (versus beginning at $150,000 and reduced to $0 at $160,000 currently). In addition, the Act clarifies that corporations and other entities are entitled to make contributions to Education IRAs and the phaseout of the annual contributions does not apply to contributors other than individuals. [Act Secs. 401(a), 401(b), 401(e). IRC Secs. 530(b)(1)(A)(iii), 530(c)(1). Tax Facts 1 (2001): Q 248.] The Act also allows contributions to an Education IRA for a taxable year to be made up until the due date (not including extensions) for filing the tax return. This is the same rule that applies to traditional and Roth IRAs. And, finally, the Act changes the deadline for distributing an excess contribution (and earnings thereon) without imposition of a 6% penalty tax from before the contributor s tax return due date for the tax year in which the contribution was made to before the first day of the sixth month of the taxable year following the taxable year in which the contribution was made. [Act Secs. 401(f). IRC Secs. 530(b), 530(d)(4). Tax Facts 1 (2001): Q 248.] Qualified Education Expenses The Act greatly expands what education expenses will qualify to be paid taxfree from an Education IRA. Qualified education expenses are no longer limited to qualified higher education expenses. Qualified elementary and secondary education expenses can also be paid tax-free. Such expenses include expenses for tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment, that are incurred in connection with the enrollment or attendance of the designated beneficiary at a public, private, or religious school that provides elementary or secondary education (K - 12) as determined under state law. In addition, the following expenses are covered: expenses for room and board, uniforms, transportation and supplementary items and services (including extended day programs) that are required or provided by such schools and expenses for any computer technology or certain equipment or internet access and related services if such technology, equipment, or services are to be used by the beneficiary and the beneficiary s family during any of the years the beneficiary is in school. Expenses for software designed for sports, games, or hobbies are not included unless the software is predominantly 13

17 TAX RELIEF 2001 educational. With respect to the rules for qualified higher education expenses, the Act now allows the limitation with respect to room and board to be the actual invoice amount charged to the student residing in housing owned or operated by the eligible educational institution if that is greater than the amount applicable to the student in calculating costs of attendance for federal financial aid programs under Section 472 of the Higher Education Act of 1965, as in effect on June 7, [Act Sec. 401(c). IRC Secs. 530(b)(2), 530(b)(4). Tax Facts 1 (2001): Q 248.] Special Needs Beneficiaries The Act waives the age limitations for special needs beneficiaries. Thus, contributions need not stop at age 18 for special needs beneficiaries and the balance in an Education IRA need not be distributed within 30 days after a special needs beneficiary attains age 30. In addition, the new beneficiary of an Education IRA by way of a rollover or a change in beneficiary can be 30 or over as long as the new beneficiary is a special needs beneficiary. A special needs beneficiary is to be defined in Treasury regulations; however, according to the Conference Report, a special needs beneficiary will include an individual who because of a physical, mental, or emotional condition (including learning disabilities) requires additional time to complete his or her education. [Act Sec. 401(d). IRC Sec. 530(b)(1). Tax Facts 1 (2001): Q 248.] Coordination with Qualified Tuition Program The Act repeals the excise tax of 6% on contributions made by any contributor to an Education IRA on behalf of a beneficiary where a contribution was also made to a qualified tuition program for the same beneficiary other than from the Education IRA itself. If the amount of qualified education expenses is less than the aggregate distributions from an Education IRA and the qualified tuition program, then the taxpayer must allocate such expenses among such distributions for purposes of determining the amount of the exclusion under each. [Act Sec. 401(g). IRC Sec. 530(d)(2)(C)(i). Tax Facts 1 (2001): Q 248.] Coordination with Education Credits Finally, the Hope Scholarship Credit or the Lifetime Learning Credit cannot currently be claimed in a tax year in which distributions from an Education IRA on behalf of the same student are excluded from income. The Act permits the taxpayer to claim a Hope Scholarship Credit or Lifetime Learning Credit for the same taxable year as amounts distributed from an Education IRA on behalf of the same student are excluded as long as there are sufficient qualified education expenses to cover both. [Act Sec. 401(g). IRC Sec. 530(d)(2)(C)(ii). Tax Facts 1 (2001): Q 248.] QUALIFIED TUITION PROGRAMS Private Institutions May Sponsor Qualified Tuition Programs Under current law, IRC section 529(b)(1) provides that a qualified State tuition program is a program established and maintained by a state or agency or instrumentality thereof that meets certain requirements and that allows an individual 14

18 EDUCATION INCENTIVES taxpayer to: (1) purchase tuition credits or certificates on behalf of a designated beneficiary, or (2) make contributions to an account established to fund the qualified higher education expenses of a designated beneficiary. The Act expands the definition of qualified tuition program to include certain prepaid tuition programs established or maintained by one or more eligible educational institutions. These may be private institutions (such as private colleges and universities) whose programs satisfy certain requirements set forth in IRC section 529(b) (i.e., cash contributions, separate accounting for designated beneficiaries, no investment direction by contributors or beneficiaries, no pledging of any interest as security, and no excess contributions). Thus, the term qualified tuition program means a state-sponsored qualified tuition program or a private qualified tuition program. Accordingly, the word state has been stricken from the name qualified tuition program. In order to be treated as a qualified tuition program the private program must meet two requirements. First, the program must have received a ruling or determination that it meets the applicable requirements for a qualified tuition program. Second, the program must provide that assets are held in a qualified trust. For these purposes, qualified trust is defined as a domestic trust for the exclusive benefit of designated beneficiaries that meets the requirements set forth in the IRA rules, (i.e., a trust maintained by a bank, or other person who demonstrates that it will administer the trust in accordance with the requirements, and that the trust assets will not be commingled with other property, except in a common trust fund or common investment fund). Contributions to Private Qualified Tuition Programs In the case of a private qualified tuition program, individuals may purchase tuition credits or certificates, but may not make contributions to a savings account plan (as is the case with state-sponsored qualified tuition programs). Distributions from Qualified Tuition Programs Currently, a distribution from a qualified tuition program is generally included in the gross income of the distributee under the rules of IRC section 72. Distributions are treated as representing a pro rata share of the principal and accumulated earnings in the account. The Act amends the IRC to provide that distributions (cash and in-kind) from state-sponsored qualified tuition programs used to pay qualified higher education expenses will be excludable from gross income for tax years after December 31, The exclusion from income will be extended to private qualified tuition programs for distributions made in tax years after December 31, 2003 to the extent that those distributions are used to pay qualified higher education expenses. (Cash distributions will be excludable from gross income to the extent that they do not exceed the qualified higher education expenses. Any excess amount will be includable in gross income, but will be reduced by a proportion that is equal to the ratio of expenses to distributions.) 15

19 TAX RELIEF 2001 Under current law, nonqualified distributions (e.g., any refund of earnings not used for qualified higher education expenses of the designated beneficiary) are required to be subjected to a more than de minimis penalty. The Act provides that the penalty for a nonqualified distribution will be a 10% tax on the amount of a distribution from a qualified tuition plan that is includable in gross income. (This is similar to the additional tax that applies to such distributions from Education IRAs.) Rollovers to Different Programs The Act also provides that a transfer of credits (or other amounts) for the benefit of the same designated beneficiary from one qualified tuition program to another is not considered a distribution. However, only one transfer within a 12-month period can receive this rollover treatment. This amendment is intended to allow a transfer between (1) a prepaid tuition program and a savings program maintained by the same state, or (2) a transfer between a state-sponsored plan and a prepaid private tuition program. Coordination with Hope and Lifetime Learning Credits According to the conference report, under current law, to the extent that a distribution from a qualified tuition program is used to pay for a qualified tuition and related expenses, a beneficiary may claim the Hope Scholarship Credit or Lifetime Learning Credit with respect to such tuition and related expenses. The Act clarifies that starting after 2001, a taxpayer can claim a Hope Scholarship Credit or Lifetime Learning Credit for a taxable year and exclude from gross income amounts distributions from a qualified tuition program but only if the distribution is not used for the same expenses for which a credit was claimed. Definitions The Act amends the term member of the family to include any first cousin of the designated beneficiary. First cousins were not included in this term under prior law. The term qualified higher education expenses is amended to include expenses incurred in connection with the enrollment or attendance of a special needs beneficiary. Except as otherwise stated above, the provisions will apply to tax years beginning after December 31, [Act Sec IRC Sec Tax Facts 1 (2001): Q 710. Tax Facts 2 (2001): Q 411.] MODIFICATIONS TO STUDENT LOAN INTEREST DEDUCTION An above-the-line deduction is available to certain taxpayers for interest paid on qualified education loans. The deduction is equal to the amount of interest paid by the taxpayer, subject to a maximum deduction amount and certain income limitations. The maximum allowable annual deduction is $2,

20 EDUCATION INCENTIVES Under current law, this deduction is available only with respect to interest paid on a qualified education loan during the first 60 months in which interest payments are required (i.e., the covered period). The maximum allowable deduction is currently phased out ratably for taxpayers with modified adjusted gross income between the following income levels: Filing Status Threshold - Upper Limit Single $40,000 - $55,000 Married Filing Jointly $60,000 - $75,000 Increase in Income Limitation The Act adjusts the phaseout ranges by increasing the threshold amounts and upper limit amounts as follows: Filing Status Threshold Upper Limit Single $50,000 - $65,000 Married Filing Jointly $100,000 - $130,000 These income phaseout ranges will be adjusted for inflation after Elimination of 60-Month Limit The Act repeals the 60-month limit on the time period for which interest paid on a qualified education loan is deductible. Consequently, student borrowers can generally now deduct interest over the full period of their student loans. The Act also eliminates the restriction which provided that voluntary payments of interest are not deductible. Voluntary payments of interest would include interest paid while a student loan is in forbearance status. The provision is effective for interest paid on qualified education loans after December 31, [Act. Sec IRC Sec Tax Facts 1 (2001): Q 721.] NEW DEDUCTION FOR HIGHER EDUCATION EXPENSES The Act provides a new above-the line deduction for qualified higher education expenses up to $3,000 for taxpayers in certain income ranges. The provision defines qualified tuition and related expenses in the same manner as for purposes of the Hope Scholarship Credit. Qualified tuition and related expenses are tuition and fees required for the enrollment or attendance of the taxpayer, the taxpayer s spouse, or any dependent of the taxpayer (for whom he is allowed a dependency exemption) at an eligible education institution. 17

21 TAX RELIEF 2001 The new deduction is not available to married individuals filing separate returns. Dollar Limitations For 2002 and 2003, the maximum deduction of $3,000 is available for a taxpayer with adjusted gross income that does not exceed the limits shown below: Filing Status Income Limit Single $65,000 Married Filing Jointly $130,000 Any other taxpayer $0 For 2004 and 2005, the Act provides a maximum deduction of $4,000 for a taxpayer with adjusted gross income that does not exceed the limits shown below: Filing Status Income Limit Single $65,000 Married Filing Jointly $130,000 A more limited deduction of $2,000 is available in 2004 and 2005 for a taxpayer with adjusted gross income that falls within the limits shown below: Filing Status Over But not More Than Single $65,000 $80,000 Married filing jointly $130,000 $160,000 Taxpayers with adjusted gross incomes above these limits would not be entitled to a deduction. Coordination of Deduction with Other Education Benefits The deduction for qualified higher education expenses may not be combined with the Hope Scholarship or Lifetime Learning Credit in the same year with respect to the same student. Also, no deduction will be permitted for any qualified higher education expenses that are taken into account in determining (1) the amount excludable due to a distribution from an Education IRA, or (2) the amount of interest excludable for an education savings bond. 18

22 EDUCATION INCENTIVES Finally, a taxpayer may not claim a deduction for the amount of a distribution from a qualfied tuition plan that is excludable from income, but the taxpayer may deduct the amount of a distribution from a qualified tuition plan that is not attributable to earnings. Example: If a taxpayer received a distribution of $100 from a qualified tuition plan that was used for tuition, and $10 represented earnings (which would be excludable under Section 529, see page 21), the taxpayer would be entitled to deduct the remaining $90, which represents a return of contributions. On the other hand, if the distribution were from an Education IRA, the $90 would not be eligible for the deduction. The new IRC provisions are effective for payments made in tax years beginning after December 31, 2001 and before January 1, [Act. Sec IRC Sec. 222.] Employer-Provided Education Assistance Exclusion This exclusion has been made permanent and broadened to include graduate education. The provision was previously scheduled to expire after December 31, [Act Sec IRC Sec Tax Facts 1 (2001): Q 702.] 19

23 RETIREMENT PLAN PROVISIONS RETIREMENT PLAN PROVISIONS IRAS Annual Contributions The Act increases the maximum annual contribution amounts for traditional and Roth IRAs beginning in The amount increases to $3,000 for taxable years beginning in 2002 through 2004, $4,000 for 2005 through 2007, and $5,000 for 2008 through In addition, the $5,000 amount will be indexed for inflation in increments of $500 for years beginning after Also, the maximum annual contribution amount for taxable years beginning in 2002 through 2005 is increased by $500 for individuals who have attained the age of 50 before the close of the taxable year. This catch-up amount increases to $1,000 for taxable years beginning in 2006 and thereafter. It should be noted that the maximum annual contribution is still limited to the lesser of the increased dollar limit or 100% of compensation. [Act Sec IRC Sec. 219(b). Tax Facts 1 (2001): Q 227, Q 228.] Deemed IRAs For plan years beginning after December 31, 2002, a qualified plan, Section 403(b) tax sheltered annuity plan or eligible Section 457 governmental plan may allow employees to make voluntary employee contributions to a separate account or annuity established under the plan. If such account or annuity meets the rules for traditional IRAs under Section 408 or for Roth IRAs under Section 408A, then such account or annuity will be deemed an IRA and not a qualified employer plan. A voluntary employee contribution is any non-mandatory contribution that the individual designates as such. Such deemed IRAs will not be subject to the IRC rules governing the employer plan; however, they will be subject to the exclusive benefit and fiduciary rules of ERISA to the extent they otherwise apply to the employer plan. [Act Sec IRC Sec. 408(q). Tax Facts 1 (2001): Q 222.] Nonrefundable Credit for Elective Deferrals and IRA Contributions A temporary, nonrefundable credit for elective deferrals and for contributions to a Traditional or Roth IRA is available to certain lower-income taxpayers for taxable years beginning after December 31, 2001 and before January 1, The credit is allowed against the sum of the regular tax and the alternative minimum tax (minus certain other credits) and is allowed in addition to any other deduction or exclusion that would otherwise apply. The credit is limited to the applicable percentage of qualified retirement savings contributions up to $2,000. The applicable percentage is as follows: 21

24 TAX RELIEF 2001 ADJUSTED GROSS INCOME Joint return Head of a household All other cases Applicable Over Not over Over Not over Over Not over percentage 0 $30,000 0 $22,500 0 $15, ,000 32,500 22,500 24,375 15,000 16, ,500 50,000 24,375 37,500 16,250 25, ,000 37,500 25,000 0 For this purpose, adjusted gross income is determined without regard to the exclusion for income derived from certain foreign sources or sources within the U. S. possessions. In addition, to be eligible, the taxpayer must be at least eighteen as of the end of the tax year and must not be claimed as a dependent by someone else or be a full-time student. Qualified retirement savings contributions mean the total of IRA contributions, elective deferrals to Section 401(k) plans, Section 403(b) tax sheltered annuities, SAR-SEPs, SIMPLE IRAs, and eligible Section 457 governmental plans, and voluntary employee contributions to deemed IRAs for the taxable year, less distributions from such plans that are includable in income (and, in the case of Roth IRAs, any distributions that are not rolled over) during the testing period. The testing period is the prior two taxable years and the current taxable year, including the period up to the due date (plus extensions) for filing the federal income tax return for the current taxable year. In addition, distributions to spouses will be treated as received by the individual if the individual and the spouse file a joint return for such taxable year and the taxable year the spouse receives the distribution. For these purposes, the following distributions can be ignored: distributions treated as loans under Section 72(p); distributions of excess contributions, excess aggregate contributions, and excess deferrals; distributions of dividends paid on employer securities under Section 404(k); withdrawals of contributions made to an IRA before the due date for filing the federal income tax return; and distributions of amounts from a traditional IRA that are rolled over or converted to a Roth IRA. Example: Joe and Jennifer have an adjusted gross income of $31,000 for 2002 and they each contributed $2,000 to a traditional IRA. Neither participates in an employer-provided retirement plan and neither received any distributions during the testing period. Not only could Joe and Jennifer each deduct their $2,000 contributions, they each can also claim a credit of $400 (20% x $2,000) on their federal income tax return for Further, it should be noted that investment in the contract would not be reduced by reason of any credit received under this provision. [Act Sec IRC Sec. 25B. Tax Facts 1 (2001): Q 227, Q 228, Q 337.] 22