The tax laws continue to provide opportunities for the wise and traps for the unwary. Often, tax savings can be achieved by taking action before the year end. The information and strategies discussed in this Bulletin may or may not be appropriate for your situation. Remember to consult with your tax professional before implementing them.
Stock Market Decline Provides IRA Conversion Opportunity
A taxpayer who holds a traditional IRA may want to consider converting it to a Roth IRA. When properly done, withdrawals made during retirement from a Roth IRA can avoid federal income tax, resulting in substantial savings when compared with a traditional IRA. The problem is that converting from a traditional IRA to a Roth has a possible tax cost.
The owner generally pays income tax on some or all of the amount converted from a traditional IRA to a Roth. The decline in the stock market, however, could mean that the owner has less to convert, and therefore may pay less in tax to convert it to a Roth IRA. Before deciding to convert, a proper analysis of the situation and of the taxpayer’s eligibility to convert should be made. That analysis can be complex and may involve multiple issues including the taxpayer’s income level, age, tax bracket, projected tax bracket at retirement time, and other factors.
Individual Tax Rates Continue Modest Decline
The Economic Growth and Tax Relief Reconciliation Act of 2001 provided for a reduction of tax rates. There were two components to these rate reductions. First, the act created a new 10% tax bracket. Second, it created modest declines in tax rates above 15%. For many Americans, the full benefit of these rate cuts was not felt until 2002.
Generally, the creation of a new tax bracket may sound as if the government is increasing your taxes, but the opposite occurred here and the new 10% bracket actually did save hundreds of dollars in taxes for many Americans. Prior to the Act, the lowest income tax rate for individuals was 15%. Under the Act, some of the income in the former 15% bracket was taxed not at 15%, but at 10%. That sounds relatively simple, but it was complicated in 2001 when the government decided to accelerate the economic effects of this new tax bracket by sending rebate checks to taxpayers based on information in tax returns filed for the year 2000. Fortunately, for 2002, most of those complications have faded away, and the savings from the new 10% bracket continue. For many single individuals with taxable income of at least $6,000, the 10% bracket will save $300.
Under the Act, individual tax rates above 15% (i.e. 28%, 31%, 36% and 39.6%) were each reduced by 21% (to 27%, 30%, 35%, and 38.6% respectively). Again, that sounds simple, but there were complications last year.
For 2001, the tax rate cuts were only effective after June 30th. That meant that for 2001, blended tax rates were 27.5%, 30.5%, 35.5%, and 39.1%. That halfyear complication from 2001 is gone for 2002, so we are now benefiting from a full 1% rate cut in these brackets. How much savings does this really mean? For a married couple filing jointly with taxable income of $100,000, the rate drop from 28% to 27% could save them about $530. Combined with potential savings from the 10% bracket of $600, that’s a total of $1,130 saved in 2002.
New Tax Credit Provides Incentive to Save for Retirement
Beginning in 2002, a new tax credit will encourage taxpayers with modest incomes to contribute to IRAs and to certain employer-sponsored retirement plans. For single filers with adjusted gross income below $15,000, the credit will be 50% of the first $2,000 contributed. For joint filers with adjusted gross income below $30,000, the credit rate will be 50% and the contribution taken into account can be up to $2,000 for each spouse. The credit is reduced as income rises and is completely eliminated for single filers with adjusted gross income above $25,000 ($50,000 for joint filers).
There are many other factors to apply in determining the size of the credit. For example, the credit cannot be more than the amount of tax that you would otherwise have paid (disregarding any refundable credits or the adoption credit). The credit may also be reduced by distributions made within certain time periods. Not everyone can qualify for the credit. For example, restrictions apply to taxpayers who are under age 18, or who are fulltime students.
Enhanced 401(k) Elective Deferral Limits
The elective deferral limit for participants in 401(k) plans (excluding SIMPLE plans) has been increased for 2002 to $11,000 and for 2003 to $12,000. For 2002, a plan can permit participants who are age 50 or over by the end of the plan year to make a catch-up contribution of $1,000. For 2003, the catch-up contribution amount will go to $2,000. The catch-up contribution amount cannot exceed the excess of the participant’s compensation over the elective deferrals that are not catch-up contributions.
Enhanced IRA Contribution Amounts for 2002
The limitations on contributions to IRAs have been increased for 2002, along with a special boost for those who are age 50 or older in 2002. The maximum contribution you can make to your traditional IRA for 2002 is the lesser of $3,000 or the amount of compensation that must be included in income. For taxpayers who are age 50 or older in 2002, the limitation is the lesser of $3,500 or the amount of compensation that must be included in income. Deductibility of your contributions depends upon several factors including participation in other retirement plans, income level, and filing status.
Similarly, for Roth IRAs, if contributions are made on your behalf only to Roth IRAs, then your contribution limit for 2002 generally is the lesser of $3,000 or the amount of your compensation that must be included in income. Again, there is a bonus for those who are age 50 or older in 2002, in that the $3,000 portion of the limitation is increased to $3,500. The ability to contribute to a Roth IRA may be reduced or eliminated depending upon modified AGI and upon filing status.
If contributions are made on your behalf to both a Roth IRA and to a traditional IRA, then your contribution limit for 2002 will be the lesser of: $3,000 ($3,500 if age 50 or older in 2002) less all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs; or your compensation that must be included in income less all contributions (other than employer contributions under a SEP or SIMPLE IRA plan) for the year to all IRAs other than Roth IRAs.
Gift Tax and Estate Tax Changes Take Hold in 2002 and Beyond
The gift tax annual exclusion amount was raised from $10,000 to $11,000. Back in 1998, Congress decided to raise the annual exclusion in increments of $1,000, commensurate with inflation. The increase to $11,000 for 2002 marks the first such inflation adjustment.
Among many other changes in the estate tax system, the applicable exclusion amount has been increased from $675,000 in 2001 to $1,000,000 for 2002. In short, this means that, with proper planning, a married couple may be able to transfer up to $2,000,000 to their children without paying any federal estate tax. This amount is anticipated to continue to increase in the future.
From a state perspective, however, the estate tax picture may be a bit more grim. In the past, the federal government allowed the estate to take a tax credit for death taxes paid to the state. The size of the credit was limited, but many states opted to tax the estate only to the extent of the federal credit. Thus, for many estates, the cost of the state death tax was precisely offset by a federal credit, and the real cost to the estate for the state tax was zero. This seemingly tax-friendly scenario is becoming more complicated for multiple reasons.
First, the federal government is reducing the amount of the credit available by 25% for 2002. Further credit reductions are scheduled for future years. Many state governments, however, are suffering from substantial budget deficits. Wisconsin has instituted its own estate tax system, effective for deaths on or after October 1, 2002. For Wisconsin residents, the Wisconsin estate tax exemption is frozen at $675,000. Estates with a value higher than this will have to pay a Wisconsin estate tax even if the estate does not owe any federal estate tax.
New Deduction Available in 2002 for Higher Education Expenses
College tuition will be deductible in 2002! That’s the good news – sort of. Up to $3,000 of qualified tuition and related expenses will be deductible regardless of whether the taxpayer itemizes deductions or uses the standard deduction. The deduction is available for the taxpayer who paid for these items for him/herself, for the spouse, or for a dependent for whom the taxpayer claims an exemption.
There are, however, constraints that make the deduction less appealing. For example, the taxpayer cannot deduct any amount for qualified tuition and related expenses for a year if a Hope credit or Lifetime Learning credit is claimed with respect to expenses of the individual for whom the tuition and related expenses were paid. There are also income limitations. For single taxpayers, modified adjusted gross income must be below $65,000 and for joint filers modified adjusted gross income must be below $130,000.
Tax Help for Teachers
The IRS is advising teachers to save their receipts for purchases of books and classroom supplies. Such out-of-pocket expenses could lower their taxes. Educators in both public and private schools could benefit from this change.
Up to $250 in qualified expenses may be deducted, even if the educator does not itemize his or her deductions. This change is available for expenses paid or incurred in tax years beginning during 2002 or 2003. In the past, such expenses were only deductible as a miscellaneous itemized deduction and if the taxpayer did not have enough of these miscellaneous itemized deductions, then none of them were deductible.
The educator must work at least 900 hours during a school year as a teacher, instructor, counselor, principal or aide. The school must provide elementary or secondary education, as determined under state law.
Qualified expenses include unreimbursed expenses paid or incurred for books, supplies, computer equipment (including software and services), other equipment, and supplementary materials used in the classroom. Other restrictions apply.
60-Month Limit Eliminated for Student Loan Interest Deduction
In the past, student loan interest was only deductible if paid during the first sixty months during which interest payments were required. Beginning in 2002, that requirement is eliminated.
The deduction is gradually phased-out if modified adjusted gross income is between $50,000 and $65,000. For those filing a joint return, the phase-out range is $100,000 to $130,000.
Paying for Education with Coverdell ESAs
Education IRAs have a new name: Coverdell ESAs (Education Savings Accounts). The maximum contribution has been increased from $500 to $2,000 per year. The ability to contribute is subject to phase-out limits based on modified adjusted gross income (MAGI). The phaseout limit for married taxpayers filing jointly has been increased from a 2001 range of $150,000 to $160,000, to a 2002 range of $190,000 to $220,000. Unlike prior years when contributions had to be made by December 31st, calendar year taxpayers generally have until April 15, 2003 to make a contribution for the 2002 tax year.
The definition of qualified education expenses has also been expanded to include elementary and secondary education expenses such as tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment incurred in connection with enrollment or attendance at an elementary or secondary school. Contributions for a given student should be coordinated with contributions made by others for that same student.
Riding Out the Ups and Downs of the Standard Mileage Rate for Business Auto Use
The optional mileage allowance for business use of owned or leased autos was increased from 34.5¢ per mile in 2001 to 36.5¢ per mile in 2002. The IRS cited rising fuel prices in the prior year as the reason for the increase. For 2003, however, the IRS has announced that the rate will drop to 36¢, citing a decline in gas prices over the twelve-month period ending June 30, 2002.
End of Luxury Tax May Delay New Car Purchases Until 2003
For 2002, the luxury tax on a passenger vehicle is reduced to 3% of the amount of the sales price that exceeds the base amount of $40,000. (The base amount is increased for electric vehicles and clean-fuel vehicles). A tax reduction sounds good, until you look forward just a little further. The luxury tax will expire at the end of this year, which means that buying that same car next year will cost even less, taxwise that is. The luxury tax on a $55,000 car would be $450. By waiting until next year, the tax is avoided. This might make car dealers more willing to negotiate in price to sell cars before the end of the year.
von Briesen & Roper Legal Update is a periodic publication of von Briesen & Roper, s.c. It is intended for general information purposes for the community and highlights recent changes and developments in the legal area. This publication does not constitute legal advice, and the reader should consult legal counsel to determine how this information applies to any specific situation.