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EGTRRA Lowers Rates and Expands Credits, Education Benefits In the individual tax arena, the Economic Growth and Tax Relief Reconciliation Act of 2001 amended the rates and the alternative minimum tax exemption, repealed the personal exemption and itemized deduction phaseouts, changed benefits for children and education and granted marriage penalty relief. This article analyzes these law changes.
Ronald
B. Hegt, CPA
For more information about this article, contact Mr. Hegt at (212) 572-5559 or hegt@haysco.com. Editor's note: Mr. Hegt chairs the AICPA Tax Division's Individual Taxation Technical Resource Panel.
Executive Summary
President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) into law on June 7, 2001. The EGTRRA was designed to provide $1.35 trillion in tax relief, through modifications to noncorporate tax provisions in the following broad areas:
This article discusses the EGTRRA changes affecting individuals.
Overview Most of the EGTRRA provisions are phased in over a 10-year period. To keep the cost within congressionally mandated limits, EGTRRA Section 901 states that all EGTRRA provisions are repealed for years ending (or for deaths or gifts made) after 2010. Thus, in 2011, the law reverts back as if the EGTRRA had never been enacted. To balance some of the associated revenue costs, two changes were made to the corporate estimated tax provisions. Under EGTRRA Section 801, any corporate estimated tax payment normally due on Sept. 15, 2001 was due Oct. 1, 2001. Similarly, 20% of the corporate estimated tax installment payment due Sept. 15, 2004 is now due Oct. 1, 2004. The purpose of the 15-day delay is to move the revenue from these payments from one fiscal year of the Federal government to the next, thereby transferring a portion of the 2001 fiscal-year surplus into 2002. This change shifts $32.9 billion, allowing the 2001 surplus to finance a portion of the 2002 reductions. Another $6 billion is transferred from 2004 to 2005.
Rates, Phaseout Repeal, AMT Individual Rate Reductions The EGTRRA made changes to both the stated and unstated tax rates contained in the Code. Two changes have been made to the tax brackets for individuals. First, a new 10% bracket is effective immediately; second, a rate reduction is phased in over seven years. Under EGTRRA Section 801, for tax years beginning after 2000, a 10% bracket is created for the following amounts of taxable income: $6,000 single or married filing separately (MFS), $12,000 married filing jointly (MFJ) and $10,000 head of household (HOH). These amounts rise to $7,000 single and MFS and $14,000 MFJ in 2008; the $10,000 HOH amount does not change. However, all of these amounts are adjusted annually for inflation beginning in 2009 (using 2007 as the base year). For 2001, the rate reduction from 15% to 10% is accelerated through the use of a credit. In lieu of a 2001 rate reduction, an individual (other than one who can be claimed as a dependent on another's return) is allowed a five percent credit of the income otherwise subject to the 10% rate. The credit is limited to the sum of the regular tax and AMT, reduced by nonrefundable personal credits and the foreign tax credit. The IRS will send an estimate of the credit (rebate) to taxpayers who filed timely via check in summer and fall 2001; taxpayers with extended or late-filed returns will receive their check later.1 However, no rebate checks will be mailed after 2001. The maximum check amount should be $300 if single, $500 if HOH and $600 if MFJ. However, if the refund (computed using 2000 data) is less than the actual credit computed using 2001 data, the taxpayer is entitled to an additional credit for the difference. If the rebate exceeds the otherwise allowable credit, that excess need not be returned to the IRS.
The 28%, 31% and 36% tax brackets are reduced by 0.5% in 2001, by another 0.5% in 2002, and by 1% in both 2004 and 2006. The 39.6% bracket is reduced by 0.5% in each of 2001 and 2002 and by another 1% in 2004; this bracket is further reduced by 2.6% in 2006. The rates decline as depicted in Exhibit 1.
Personal Exemption Phaseout Repeal Under current law, personal exemptions are phased out by two percent for each $2,500 ($1,250 if MFS) by which adjusted gross income (AGI) exceeds a threshold. For 2001, a couple MFJ begins to lose the benefit of personal exemptions at $199,450 of AGI ($132,950 single, $166,200 HOH, $99,725 MFS). The benefit of exemptions is totally lost at $321,950 if MFJ. EGTRRA Section 102 repeals, in stages, the disallowance of the personal exemptions. For tax years beginning in 2006 and 2007, the phaseout is only two-thirds of the otherwise phased-out amount. For 2008 and 2009, the phaseout is only one-third; the phaseout is completely repealed in 2010.
Itemized Deduction Phaseout Repeal Similarly, the EGTRRA slowly reduces the phaseout of itemized deductions for high-income taxpayers. Currently, taxpayers with AGI in excess of a threshold ($132,950 for 2001, $66,475 if MFS) must reduce their otherwise allowable itemized deductions by three percent of the excess, limited to 80% of the itemized deductions subject to disallowance. Under EGTRRA Section 103, for tax years beginning in 2006 and 2007, the disallowance is reduced by one-third; in 2008 and 2009, the reduction is two-thirds. Beginning in 2010, the EGTRRA completely repeals the itemized deduction phaseout. Observation: The effect of the rate reductions and repeal of the personal exemption and itemized deduction phaseouts is greater than just the difference between the tax rates before and after the EGTRRA.
AMT Changes EGTRRA Section 701, in recognition of the continuing effect of the AMT on more and more taxpayers, increases the AMT exemption for single taxpayers (and those MFS) by $2,000; the increase is $4,000 for those MFJ and surviving spouses. This change is only effective for tax years 2001–2004, inclusive. Observation: Although the potential effect of the AMT change is small for each taxpayer, the EGTRRA Conference Report estimates that this change will cost $13.9 billion overall.2 More telling is the estimated number of taxpayers subject to the AMT. The Conference Report estimates that 1.4 million taxpayers will pay AMT in 2001 (1.5 million would have paid it without a law change). This number rises to 5.3 million by 2004, 13 million by 2005 and 35.5 million by 2010. Thus, AMT planning will be needed for "average" taxpayers.3
Benefits for Children Child Credit The child tax credit has been increased and made available to more taxpayers. According to EGTRRA Sections 201 and 203, the current $500 per-child credit is increased in stages to $1,000 by 2010 ($600 for 2001–2004, $700 for 2005–2008, $800 for 2009). In addition, the credit will be refundable to the extent of 10% of the taxpayer's earned income in excess of $10,000 (indexed for inflation in $50 increments beginning in 2002) for 2001–2004, inclusive; the applicable percentage rises to 15% in 2005 and later. Families with more than two children are allowed an additional refundable credit to the extent the excess of their Social Security tax over their earned income credit is greater than the otherwise allowable refundable credit. Further, the refundable credit will no longer be reduced by AMT. Lastly, the refundable child credit will no longer be deemed income or support for purposes of computing welfare benefits financed with Federal funds. Beginning in 2002, the full child credit will be allowable against both regular tax and AMT.
Adoption Credit The adoption tax credit, currently $5,000 per child ($6,000 for special-needs children) was made permanent by EGTRRA Section 202 and increased to $10,000 for tax years beginning after 2001; it can be used to offset AMT. For the adoption of a special-needs child after 2001, the $10,000 credit is allowable regardless of whether the taxpayer incurs any adoption-related expenses. The AGI phaseout, currently beginning at $75,000, will begin at $150,000. The EGTRRA also permanently extends the exclusion from income for employer-provided adoption assistance; the maximum exclusion is increased to $10,000 per child, whether or not special-needs. For the adoption of a special-needs child after 2001, the $10,000 exclusion is available regardless of whether the taxpayer incurs qualified adoption-related expenses. The AGI phaseout will begin at $150,000.
Dependent Care Credit EGTRRA Section 204 increased the dependent care tax credit and eligible expenses and modified the phaseout. Currently, a maximum 30% credit is allowable for up to $2,400 of eligible expenses for one dependent and $4,800 for more than one dependent. The credit is reduced by one percent for each $2,000 of AGI in excess of $10,000, but not below 20%. Beginning in 2003, eligible expenses have been increased to $3,000 for one dependent ($6,000 for more than one), the maximum credit is 35% and the phaseout begins at $15,000 AGI. Thus, a taxpayer with $15,000 AGI will now be eligible to claim a $1,050 maximum credit, rather than the $729 currently available. The credit is fully reduced to its minimum 20% when AGI reaches $43,000.
Employer-provided Childcare Facilities To encourage employers to support childcare facilities, a credit is allowed beginning in 2002 for employer-incurred qualified childcare expenses. Under EGTRRA Section 205, the credit is 25% of qualified childcare expenses incurred and 10% of qualified expenses incurred for childcare resource and referral services. The maximum employer credit is $150,000 per tax year. "Qualified childcare expenses" include expenses incurred to acquire, construct, rehabilitate or expand childcare facilities, as well as the costs of operating or providing them. The credit is allowable whether the taxpayer incurs the costs itself or through a contract with a qualified facility, if the contract calls for providing these services to or for the benefit of the employer's employees. To the extent a credit is claimed, the associated expense is disallowed or the basis of the acquired property reduced. Any credit for costs associated with acquisition or construction of a qualified childcare facility is subject to recapture if the facility is disposed of in the 10-year period beginning with the year in which the facility is placed in service. The recapture percentage is 100% for the first three years and gradually declines to zero by the eleventh year. A credit is not allowable if benefits are provided on a discriminatory basis.
Marriage Penalty Relief Under the current Code, MFJ couples pay a marriage penalty of up to $18,000, due in part to inequities in tax brackets and the standard deduction. For example, the 15% tax bracket for single taxpayers, as in effect prior to the EGTRRA, is 59.6% of the MFJ bracket; thus, two single taxpayers have almost 20% more of their income taxed at the 15% rate than an MFJ couple. Similar inequities exist in the other tax brackets as well as in the standard deduction; the current single standard deduction is 60% of the MFJ amount. Many other phaseouts and limits do not treat MFJ couples the same as two singles.4 To provide limited relief, EGTRRA Sections 301 and 302 increase the joint standard deduction and 15% bracket; thus, at the end of the phase-in period, the joint amounts will be twice the single amounts. Exhibit 2 shows the size of the new joint amounts as a percentage of the single amount.
When fully phased in, the 15% bracket change (assuming no inflation in bracket amounts after 2001) will save married taxpayers $1,157. The standard deduction savings will vary depending on a taxpayer's bracket. Using 2001 amounts, a couple MFJ will see their standard deduction increase from $7,600 to $8,800 in 2009. In the highest bracket (35% in 2009) and fully phased in, this change will relieve $240 of marriage penalty.
Education Benefits Education IRAs The Taxpayer Relief Act of 1997, Section 213(a), created Sec. 530, allowing a taxpayer to establish an Education IRA—a trust or custodial account to pay a single named beneficiary's qualified education expenses (QEEs). Annual contributions were limited to $500 per beneficiary per year. The annual contribution limit was phased out for single filers with $95,000–$110,000 of modified AGI (MAGI) ($150,000–$160,000 if MFJ). Contributions had to end when the beneficiary reached age 18. QEEs were expenses incurred for undergraduate- or graduate-level course work and included tuition, fees, books, supplies and equipment. Room and board were covered if the beneficiary was at least a part-time student, limited to (1) $1,500 per academic year for students without dependents, living at home with parents or guardians; (2) the institution's normal charge for students without dependents living in institution-owned or –operated housing; or (3) $2,500 for the academic year for all other students. QEEs also included amounts paid or incurred to purchase tuition credits or make contributions to a qualified state tuition program (QSTP) for the Education IRA beneficiary. Contributions to an Education IRA were made after-tax; distributions were taxed under the Sec. 72 annuity rules. Distributions thus consisted of contributions and earnings that might be subject to tax, depending on the amount of QEEs. The nontaxable portion of a distribution was determined by multiplying the distribution by the ratio that the total contributions bore to the account balance when the distribution was made, under Secs. 72(e)(9) and 530(d). Earnings were generally not taxed until distribution, and were excluded from income to the extent used to pay QEEs. Distributed earnings not used to pay QEEs were includible in the beneficiary's gross income and subject to a 10% penalty. In certain cases, the penalty did not apply. Under Sec. 530(d)(5), unused Education IRA balances could be rolled over tax-free into Education IRAs created for other family members and did not count toward the $500 limit. Account balances remaining after a beneficiary reached age 30 were deemed distributed within 30 days of the date that age was reached. If the beneficiary died before reaching 30, the distribution had to be made within 30 days of death, according to Sec. 530(b)(1)(E). If the beneficiary claimed an exclusion under the Education IRA provisions, neither the Hope credit nor the Lifetime Learning credit could be claimed for the same tax year. The exclusion had to be waived to claim these education credits, under Sec. 25A(e)(2). In addition, a six-percent excise tax was imposed on excess contributions to an Education IRA, under Sec. 4973 (i.e., contributions for the tax year that exceeded the allowed limit (e.g., $500) or also contributed to a QSTP program for the same beneficiary). Under EGTRRA Section 401, the maximum annual contribution to an Education IRA is increased to $2,000; accounts may now also be used for elementary and secondary education expenses, whether incurred in a public, private or religious school. Additional amendments:
Maximum yearly contribution: The maximum contribution that can be made to an Education IRA annually is increased from $500 to $2,000, for tax years beginning after 2001 (Sec. 530(b)(1)(A)(iii)). The 6% excise tax on excess contributions is triggered if contributions for the year exceed $2,000. Families with many children can roll over unused portions of an Education IRA for a younger child's use. No marriage penalty: The MAGI used to determine the contribution limit phaseout range for MFJ taxpayers is increased to twice the amounts applicable for single filers, eliminating the marriage penalty aspect. Thus, the $2,000 annual contribution limit is phased out for joint filers with MAGI of $190,000–$220,000 ($95,000–$110,000 if single). Contributions from entities (e.g., corporations) are not subject to the phaseout rules. Thus, individuals subject to the phaseout rules should have a child, friend, relative or corporation, trust or other entity make the contribution. Elementary and secondary education: These expenses can now be paid for with Education IRA distributions. Specifically, QEEs include expenses incurred while the beneficiary is in attendance or enrolled at an elementary or secondary school (i.e., grades K–12, as defined by state law), whether public, private or religious. Such expenses include tuition, fees, books, supplies and equipment and expenses for special-needs services of a special-needs beneficiary. Qualified elementary and secondary education expenses differ, however, in that they include expenses for:
QSTP contributions: Contributions to a QSTP under Sec. 529(b) are QEEs payable from an Education IRA. Contributions made with tax-free earnings are not taken into account under the Sec. 72 annuity rules. Special-needs beneficiaries: Regulations can be issued to allow contributions to an Education IRA to continue past age 18 for a special-needs beneficiary, and for distributions to continue and rollovers to occur past age 30. This would apply to an individual who, due to a physical, mental or emotional condition (including a learning disability), requires additional time to complete an education. Timeliness issues: Contributions can be made by the return due date (without extensions) for the tax year of the contribution. Thus, a calendar-year taxpayer would have until April 15, 2003, to make a 2002 contribution. The contribution is deemed paid on the last day of the tax year (here, Dec. 31, 2002). The time for making corrective withdrawals of excess contributions is also extended. The 10% penalty tax and the six-percent excise tax on excess contributions will not be imposed if distributed by May 30 following the tax year of the contribution. The distribution must be accompanied by the net earnings thereon. Education credits and QSTPs: Under EGTRRA Section 402, a student can take advantage of the Education IRA provisions, as well as the Hope and Lifetime Learning credits and a QSTP, in the same tax year. A beneficiary is no longer required to waive tax-free treatment for distributions from an Education IRA to use education credits during the same tax year; instead, the taxpayer must elect not to claim the education credits for qualified tuition and related expenses paid during the tax year, according to Secs. 25A(e) and 530(d)(2)(C); further, no six-percent excise tax will apply. QEEs are first reduced for scholarships or fellowships excludible from income under Sec. 117 and any other tax-free educational benefits, then reduced for amounts taken into account in determining the education credits under Sec. 25A. If a student receives distributions from both an Education IRA and a QSTP under Sec. 529 that together exceed these remaining expenses, the expenses must be allocated between the distributions. Finally, Education IRAs are now known as Coverdell Education Savings Accounts.5
Employer-provided Educational Assistance EGTRRA Section 411 makes the $5,250 annual exclusion for employer-provided educational assistance permanent for both undergraduate and graduate courses, effective for tax years beginning in 2002. The current provision was due to expire for courses beginning after 2001.
Student Loan Interest EGTRRA Section 412 modified the deduction for student loan interest. The new law repeals both the (1) limit on the number of months of interest for which a deduction can be taken and (2) nondeductibility of voluntary interest payments. Further, the income phaseout ranges for eligibility for the deduction were increased from $50,000 to $65,000 for single taxpayers, and from $100,000 to $130,000 for MFJ taxpayers; these ranges are adjusted annually for inflation after 2002.
QHEE Deduction EGTRRA Section 431 permits taxpayers an above-the-line deduction for qualified higher education expenses (QHEEs), defined as under the Hope credit. In 2002 and 2003, taxpayers with AGI that does not exceed $65,000 ($130,000 MFJ) can deduct up to $3,000 of QHEEs per year. The deduction does not phase out; it is lost completely when the AGI threshold is reached. In 2004 and 2005, the deduction increases to a $4,000 maximum at those same levels of AGI; taxpayers with AGI of $60,000–$80,000 ($130,000–$160,000 MFJ) can take a maximum $2,000 deduction. Special rules bar use of the deduction in conjunction with the Hope or Lifetime Learning credit, an Education IRA distribution or a distribution of earnings from a qualified tuition plan.
Conclusion The changes made by the EGTRRA are beneficial for individuals, but in some cases (e.g., AMT), Congress did not go far enough. Nevertheless, the EGTRRA modifications are welcome and will provide some relief. |
