2001 Tax Act
The Bush Tax Cut is for real after all! Over the Memorial Day weekend, Congress signed off on legislation
that significantly reduces individual tax rates and eventually repeals the federal estate tax. Numerous other
breaks are included as well. This letter will inform you about the major provisions in the new law and what
they mean for you. So let’s get started.
Individual Rate Cuts Phased-in Between Now and 2006
The new law eventually reduces the existing 28% rate bracket to 25%, the 31% bracket to 28%, the 36%
bracket to 33%, and the 39.6% bracket to 35%. These changes are not fully phased-in until the 2006 tax
year. For this year, the existing rates are effectively reduced by one half percent (the 28% rate goes to
27.5%, and so on). The reduced rates will be reflected in revised payroll tax withholding tables for the
second half of this year. For 2002, the rates will drop to 27%, 30%, 35%, and 38.6%, respectively. The 15%
rate remains unchanged.
In addition to reducing the current tax brackets, a new 10% bracket has been created out of a portion of the
current 15% tax bracket. The 10% rate applies to the first $6,000 of taxable income for singles, the first
$10,000 for heads of households, and the first $12,000 for joint filers. Although the new 10% bracket is
retroactive to January 1 of this year, nearly all taxpayers will benefit from the lower rate not when they file
their 2001 return but by receiving a refund check from the IRS some time before the end of this year. Most
taxpayers who filed as a single in 2000 will receive $300 checks (5% of the $6,000 bracket amount now
taxed at 10% rather than 15%), those who filed as heads of households in 2000 will normally receive $500
checks (5% of $10,000), and joint filers generally will receive $600 checks (5% of $12,000). Certain
taxpayers, such as nonresident aliens and individuals who can be claimed as a dependent on the return of
someone else are not eligible for the refund checks.
Marriage Penalty Relief—Finally!
When both a husband and wife work, and especially if they each make about the same amount in income,
they typically pay more in income taxes by being married than if they were single and filing separate
returns. In ―tax speak‖ this is referred to as a marriage penalty.
Starting in 2005, the new law provides marriage penalty relief to joint filers in the form of an expanded
standard deduction amount and a wider 15% tax bracket. Once the relief is fully phased-in, the standard
deduction for joint filers will equal double the standard deduction for singles and the upper end of the 15%
tax bracket for joint filers will be twice the upper-end limit for singles.
Although billed as marriage penalty relief, these changes apply to all couples who file a joint return. Thus,
where only one spouse works, the new law increases the tax advantages of such a couple being married
and filing a joint return rather than being unmarried and filing separately.
Phase-outs for Personal Exemptions and Itemized Deductions Will Gradually Be Repealed
Under the new law, the phase-out rule that reduces personal exemption deductions of high-income
taxpayers will eventually be repealed. This favorable change kicks in starting in 2006 but won’t be fully
effective until 2010. Specifically, the limit on personal exemptions that would otherwise apply under the
phase-out rule is reduced by one-third for tax years 2006 and 2007 and by two-thirds for 2008 and 2009.
The phase-out rule is then completely repealed in 2010.
Similarly, the itemized deductions phase-out rule for high-income taxpayers will gradually be repealed. The
limit on deductions that would otherwise apply under the phase-out rule is reduced by one-third for tax
years 2006 and 2007 and by two-thirds for 2008 and 2009. The phase-out rule is then completely repealed
Child Tax Credit Will Gradually Increase to $1,000
Under the new law, you are allowed a $600 tax credit in 2001 for each under-age-17 qualifying dependent
child. This is up from $500 last year. The credit then increases to $700 in 2005, to $800 in 2009, and
eventually tops out at $1,000 in 2010. However as under prior law, the credit is ―phased out‖ starting at
adjusted gross income (AGI) of $75,000 if you file as a single or head of household and starting at AGI of
$110,000 if you file jointly. Thus, high-income taxpayers will remain ineligible for this credit.
Adoption Tax Breaks Expanded
The new law permanently extends the adoption tax credit and increases the maximum credit amount to
$10,000 (up from the current maximum of $6,000 for special needs children). The starting point for phase-
out of the credit is increased to AGI of $150,000 (up from the current $75,000). Phase-out will be complete
at AGI of $190,000. Similarly, the income exclusion for employer-provided adoption assistance is increased
to $10,000. The starting point for the phase-out of this benefit is also increased to AGI of $150,000, with
phase-out complete once AGI reaches $190,000. All these changes are effective for the 2002 tax year.
Dependent Care Breaks Expanded
The tax credit for dependent care expenses incurred to allow you to work will be expanded to cover up to
$3,000 of expenses (up from $2,400). If you have two or more qualifying dependents, the credit will cover
up to $6,000 of expenses (up from $4,800). The maximum credit percentage for low-income taxpayers will
be increased to 35% (up from 30%). However, as under prior law, most taxpayers will qualify for a only 20%
credit, which will translate into a maximum credit amount of $600 for one qualifying dependent or $1,200 for
two or more qualifying dependents. These changes are effective for the 2003 tax year.
In addition, the new law establishes an employer tax credit for companies that provide employee child care
and employee child care resource and referral services. This change is effective in 2002.
New and Expanded Education Breaks
The new law includes several new and expanded tax breaks related to education. First, beginning next year
the maximum annual contribution to education IRAs will be increased from the current $500 to a much-
more-reasonable $2,000 and the AGI phase-out range that limits education IRA contributions for high-
income taxpayers will be increased to $190,000 to $220,000 for joint filers (up from the current range of
$150,000 to $160,000). In addition, tax-free education IRA payouts will be allowed for elementary and
secondary school expenses, including those to attend private and religious K–12 schools. Qualifying
expenses include not only tuition, fees, and academic tutoring, but also uniforms, transportation, and even
the cost of computers and related equipment (plus most software and the cost of providing Internet access)
if used by the student and the student’s family during any of the years the student is in school.
Beginning next year, payouts from state-sponsored qualified tuition programs (QTPs) to cover college costs
will become tax-free. (Under prior law, these programs offered tax-deferral benefits, but payouts were
eventually taxed at the student’s rate.) In addition, the new law will eventually permit private educational
institutions to sponsor tax-free QTPs that offer prepaid tuition credits or certificates. (Unlike state-sponsored
QTPs, however, these private QTPs will not be able to offer college savings account plans.)
The phase-out rule that limits college loan interest deductions for high-income taxpayers will be liberalized.
Effective next year, the phase-out range will be between AGI of $50,000 and $65,000 for singles (up from
the current range of $40,000 to $55,000). The phase-out range for joint filers will be increased to AGI
between $100,000 and $130,000 (up from the current range of $60,000 to $75,000). Under existing law,
deductions are only allowed for 60 month’s worth of interest payments. The new law lifts the 60-month
The current-law rule allowing tax-free employer reimbursements for up to $5,250 of an employee’s annual
education expenses has been made permanent. Starting in 2002, tax-free reimbursements for graduate
courses will also be allowed (currently, only undergraduate courses qualify).
Finally, the new law establishes a brand-new deduction for college costs. Starting in 2002, taxpayers will be
able to deduct up to $3,000. However, this break is eliminated for singles with AGI in excess of $65,000
and for joint filers with AGI above $130,000. For 2004 and 2005, the maximum deduction amount will
increase to $4,000. Also, in 2004 and 2005 singles with AGI between $65,000 and $80,000 will be entitled
to a maximum $2,000 deduction. Ditto for joint filers with AGI between $130,000 and $160,000.
Unfortunately, this new break will expire after 2005 unless Congress takes further action.
Larger Retirement Account Contributions
The new law also includes a number of changes in the retirement plan area. The key point here is that you
(or your employer) will soon be allowed to make bigger contributions to most types of tax-advantaged
retirement accounts. Here are the specifics.
The maximum allowable annual contribution to IRA accounts (including Roth IRAs) will gradually be
increased to $5,000 in 2008. The limit for 2002 will be $3,000. Taxpayers age 50 and above will be allowed
to contribute a bit more than the ―normal‖ maximum. For these taxpayers, the limit for 2002 will be $3,500;
increased to $6,000 in 2008.
The maximum allowable annual contribution to 401(k), 403(b), and 457 accounts will gradually be
increased to $15,000 in 2006. The maximum for 2002 will be $11,000.
The maximum allowable annual contribution to SIMPLE accounts will gradually be increased to $10,000 in
2005 (up from $6,500 for this year). The maximum for 2002 will be $7,000.
The maximum annual contribution to a defined benefit plan will be increased to $40,000 (up from $35,000),
effective for 2002.
The maximum annual benefit payable from a defined benefit pension plan will be increased to $160,000 (up
from $140,000), effective for 2002.
The maximum annual compensation taken into account in determining allowable retirement plan
contributions will be increased to $200,000 (up from $170,000), effective for 2002.
Maximum allowable contributions to profit-sharing and stock bonus plans will be increased to 25% of
compensation (up from 15%), effective for 2002.
Finally, sole proprietors, partners, LLC members, and more-than-2% shareholder-employees of
S corporations will be allowed to borrow from their tax-advantaged retirement accounts (typically under
Keogh plans) on the same basis as garden-variety employees. This change is effective for 2002. However,
borrowing against IRA and SEP accounts will continue to be prohibited, as under existing law.
Limited (Very Limited) Alternative Minimum Tax Relief
To help prevent the alternative minimum tax (AMT) from eating up all the savings from these favorable
changes to the ―regular tax‖ rules, the AMT exemption is increased by $2,000 for single filers and by $4,000
for joint filers, effective for 2001 through 2004. This limited relief will expire after 2004, unless Congress
takes further action.
Estate Tax Gradually Repealed
A number of complicated, but generally favorable, changes were made to the federal estate and gift tax
rules. The key point is that the estate tax is scheduled for complete repeal in 2010 while the gift tax is being
retained. Between now and then the estate tax will continue to exist, but with the expanded exemption
amounts listed below. (The gift tax exclusion will rise to $1 million in 2002 and remain at that level. In 2010
the maximum gift tax rate will drop to the highest individual income tax rate.)
Estate Tax Highest Estate
Calendar Year Applicable Exclusion Amount and Gift Tax Rate
2002 $ 1 million 50%
2003 $ 1 million 49%
2004 $ 1.5 million 48%
2005 $ 1.5 million 47%
2006 $ 2 million 46%
2007 $ 2 million 45%
2008 $ 2 million 45%
2009 $3.5 million 45%
2010 N/A (taxes repealed) Top individual income tax rate (gift
While the new tax law may not be everything you hoped for, it’s a whole lot better than nothing—which is
exactly what we’ve gotten since 1997. And this letter doesn’t cover all the favorable changes (it would be
way too long to read if we did). Additional breaks are available to certain types of taxpayers, such as
teachers and small businesses that sponsor employee retirement plans.
With any luck, we may see further relief specifically targeted at business taxpayers later this year or more
likely next year. We could even see new reductions in the capital gains rates. Only time, politics, and the
state of the economy will tell. In the meantime, please call with any questions regarding how the new law
affects your tax planning strategies for this year and beyond. We look forward to hearing from you.
(Personal note: Why does Congress feel a need to ―phase-in‖ these tax provisions. Would we taxpayers be
overwhelmed with too much tax relief? Would that be a bad thing?)