The New Taxes: Keep a Sharp Eye on the Calendar

Breaks are substantial, but they disappear a few years out

Washington is handing out $1.35 trillion in tax cuts. Heirs, two-earner couples, workers saving for retirement, and parents planning for college are all winners under the tax bill championed by President Bush and passed by Congress. You'd hardly think there could be a downside.

But for financial planning, the measure is a mess. "I feel as if I need a calliope playing--Congress was acting like a circus," says Thomas Ochsenschlager, director of federal taxes for accountants Grant Thornton. A carnival may be more like it, because many of these tax cuts are like the pea in the huckster's shell game--now you see them, now you don't. Pieces of the bill phase in, then phase out. And in a breathtaking budgetary sleight-of-hand, Congress decided that the entire tax law will "sunset" in 2011--bringing back today's tax rates and estate-tax system.

So, planning your finances for the next decade requires a leap of faith: You've got to believe that future Congresses will renew the tax-cut IOUs that today's lawmakers wrote. "People have a right to plan ahead and know what the law will be," grouses George Cushing, an estate attorney with Day, Berry & Howard in Boston. Such certainty may be out of reach--but for now, at least, here's what the law says:

RATE CUTS. The bill immediately creates a new 10% tax bracket, down from 15%, on a couple's first $12,000 in taxable income ($6,000 for single filers)--worth $600 in savings for a couple. Higher brackets are cut in 2001, 2002, 2004, and 2006. By then, today's 28%, 31%, and 36% rates will have been cut by 3 percentage points, and the top 39.6% rate will have fallen to 35%.

The message is clear: If you can put off collecting income, you'll pay less tax. "My clients who were considering deferred compensation programs are finding a lot more urgency now," says Martin Nissenbaum, director of personal taxes for accountants Ernst & Young. You'll also want to prepay next year's deductible expenses--such as real estate tax or professional subscriptions--because they're worth more in 2001.

EDUCATION SAVINGS. For parents, the new tax bill is "the gift of a lifetime," says Judy Miller of College Solutions, an Alameda (Calif.) planning firm. The biggest gift: If you've set up a "529 plan"--a prepaid tuition account or a state-sponsored savings plan--neither you nor your kids will owe any tax when those funds are withdrawn to pay college expenses, after Jan. 1. Under current law, such withdrawals are taxed at the student's tax rate.

The new law also boosts the amount you can put into a child's Education IRA, from $500 a year to $2,000, as of next year. Couples with income up to $220,000--vs. the $160,000 cap in current law--will be eligible to set up E-IRAs. And funds from E-IRAs will get tax-free treatment whether they're used for college expenses or to pay for private elementary and secondary schools.

With these new breaks for saving, "there's no reason for anyone to set up UTMAs or UGMAs," custodial accounts in a child's name that many parents use to reduce taxes on college funds, says Miller. Either an E-IRA or a 529 plan lets the parent keep control and redirect funds to another child if the first beneficiary heads for Motorcycle U. instead of State. Most parents will favor 529s because they can be far larger--up to $250,000 in some states--but E-IRAs give more control over how funds are invested, Miller says.

The new law also adds a tuition deduction, even for taxpayers who don't itemize. Starting next year, couples with incomes up to $130,000 can deduct up to $3,000 a year in college expenses; in 2004, the limit rises to $4,000. (In 2006, the deduction disappears.) The HOPE and Lifetime Learning credits are worth more than these deductions, but they phase out for parents with incomes over $80,000. The new law also increases deductions for student-loan interest.

RETIREMENT SAVINGS. Individual retirement accounts can be richer under the new law. The ceiling on tax-deductible contributions, stuck at $2,000 since 1982, will rise to $5,000 by 2008.

Employer-backed nest eggs can also grow. A worker with a 401(k) plan can save at most $10,500 of pretax income today; the new law increases that to $15,000 by 2006. (Similar plans offered by nonprofit and governmental employers will also enjoy increases.)

Starting in 2006, you can use part of your 401(k) contributions to create a Roth 401(k), modeled on the popular Roth IRA. You won't get a tax break for contributions, but all your withdrawals will be tax-free. That could be good news for your heirs, because future generations can inherit a Roth account and let it grow without income tax.

A provision designed to help women who take time out of the workforce can boost men's savings, too. Starting next year, all workers 50 years or older can make tax-free "catch-up contributions" to their IRAs and 401(k)s. For an IRA, the older worker can add up to $500 a year starting in 2002, and $1,000 a year starting in 2006. For 401(k)s, catch-ups start at $1,000 in 2002 and increase to $5,000 in 2006. Employers can match these extra contributions if they choose.

ESTATE PLANNING. The good news is, slowly but surely, the estate tax is going away. Tax publishers RIA calculate that the tax on a $10 million estate will fall from $4.92 million if the owner dies this year, to $2.93 million for a death in 2009, and to zero in 2010. The bad news: The very next year, the estate tax returns--with today's top rate of 55%. The tax on a $10 million estate will then shoot back to $4.8 million.

Needless to say, planners are fuming. "It's very bizarre tax policy," says Randi Schuster, head of family wealth planning for accountants BDO Seidman. Odds are that Congress will eventually enact something like the 2009 estate tax--with the first $3.5 million in an estate exempted from tax and a top rate of 45%--as the permanent system. For now, estate experts say you should:

-- Check your will and trusts. Most estate plans direct assets into two trusts. The "bypass" or "credit-shelter" trust gets enough assets to use up the estate tax's unified credit, which is now $675,000, and is set up to benefit the owner's children. The rest of the estate goes into a marital trust for the spouse.

The new law boosts the unified credit to $1 million next year, and to $3.5 million by 2009. For an estate of $5 million, the standard estate plan means the spouse's inheritance would fall from $4.35 million this year to $1.5 million in 2009. "You run the risk of leaving your spouse without sufficient resources," says Schuster, "especially if it's a second marriage" and children from the first union won't share with their step-parent. Wills should be written with a cap--either a dollar figure or a percentage of the estate--on the children's credit-shelter trust.

-- Make gifts. 'Tis better to give than to bequeath, because the tax you'll pay on a gift is less than the tax your heirs will pay on their inheritance. With the estate tax here for at least nine more years, it makes sense to give away property. Gifts of assets likely to appreciate--hot stocks or stakes in privately held companies--are the best for tax-cutting.

-- Watch your statehouse. The estate-tax provisions will cost states $6 billion in annual revenue. States are likely to respond with new taxes on estates that will complicate your will.

-- Keep records. Under the estate tax, heirs get a break on capital gains: They can value assets as of the owner's date of death and only pay taxes on capital gains that occur after that. In 2010, when the estate tax is repealed, this "stepped-up basis" disappears (only to reappear along with the estate tax in 2011). Then, heirs who sell inherited assets will owe taxes on all gains from the assets' original purchase price. (The law exempts $1.3 million in gains for each estate; spouses can exempt an additional $3 million.)

This accounting nightmare won't take effect unless the estate tax is permanently repealed, which seems unlikely. Still, smart investors will start keeping detailed records on the prices they pay, especially for hard-to-value assets such as partnership shares or family businesses.

AMT RELIEF. Nothing better illustrates this tax bill's wallet-on-a-string tricks than the alternative minimum tax relief provision. The AMT is a parallel code designed to limit use of shelters and credits. If such breaks reduce your taxes too much, you're forced to recalculate your return without several key deductions, including those for state and local taxes. The AMT is catching more and more middle-income families, and the new tax bill will expand the AMT trap by cutting ordinary taxes without changing the AMT minimums.

Congress tried to reduce the number of taxpayers caught in this web by raising the amount of income exempt from the AMT--from $45,000 to $49,000 for couples, and from $33,750 to $35,750 for singles--effective this year. If you've been subject to the AMT, check with your accountant now. The extra breathing room may let you skip some steps you might have planned to avoid the AMT, such as putting off state tax payments.

The relief only lasts through 2004; by 2010, the new law will double the number of taxpayers subject to the AMT, to 35.5 million. Clearly, today's lawmakers are punting this problem to future Congresses.

There's the rub. The tax bill's many appealing features--lower tax rates, relief for two-earner couples, aid for retirement and college savings--come with an acid edge of uncertainty. Enjoy the tax breaks, but keep your financial planner's phone number handy. You'll need it for years to come.

By Mike McNamee

    Before it's here, it's on the Bloomberg Terminal.