Make the most of the new tax law

Opportunities galore are yours for the taking, but some may disappear unless you act fast.

By Lawrence Farber
Contributing Writer

"Much ado about nothing!" snorted one doctor when he learned that the $1.35 trillion in tax relief promised by the new law would save him less than $1,000 in 2001. But this year's savings just hint at what's ahead.

The myriad changes in the Internal Revenue Code slated to take effect over the next decade may add up to tens—even hundreds—of thousands in tax savings for a typical doctor and his family. To get the most out of the tax breaks in store, though, you'll have to plan your strategy and take timely action, with the guidance of knowledgeable advisers.

You may already have received a "refund" check—$600 for most couples, $300 for singles—thanks to the new 10 percent rate applying to the first $12,000 ($6,000 for singles) of 2001 income. This year, joint filers will also save $5 on each $1,000 of taxable income above $45,200 (above $27,050 for singles). Potential savings accelerate from 2002 onward and reach warp speed in 2006. As you may have heard, a so-called sunset provision now in the law could bring the benefits to a screeching halt thereafter, but that provision isn't likely to remain unmodified (see "A clouded sunset").

Although all physicians will benefit from rate declines of at least 3 percentage points by 2006, married ones will get a bigger cut because a larger proportion of their income will be taxed at 15 percent. For example, a single doctor with $200,000 annual taxable income would pay almost $6,300 less in 2006 than in 2001, while a couple with the same income can expect to save nearly $7,400.

Your figures will vary, depending on your income, but whatever they are, you can take steps to improve them. Keep in mind that your deductions will save you more in the earlier years when tax rates are higher. You may already be in the habit of moving up next year's writeoffs in order to trim your tax bill for the current year. When rates hold steady, this ploy doesn't necessarily reduce the two-year total tax but puts off part of the payment for a year. Now, however, extending your planning beyond 2002 can bring you permanent savings.

You'll get a bigger tax break for any medical equipment you buy in 2002 or 2003 than you will on purchases made after 2006. The same is true for other business expenses, including loan interest—with this caveat: IRS regulations generally don't allow you to claim deductions for expenses that won't be due for payment within 12 months. But nothing in the rules says you can't arrange a loan so that the periodic payments consist only of deductible interest and return of principal is postponed, giving you bigger tax benefits up front.

Some of your investment assets might also provide opportunities for deductions that would be more valuable in the next couple of years than later on. Remember, if capital losses on stocks you sell exceed your gains, you can write off up to $3,000 a year against your regular income. And if you've been unable to claim operating losses from rental real estate you own because you had no offsetting income from other passive activities in past years, disposing of the property in 2002 could let you deduct the entire operating loss from next year's ordinary income.

Consider, too, that you may get to keep more of your investment income by pushing it into the future. The new law doesn't pare the tax on capital gains, but the bite on interest and dividends will become less painful. Say you're nearing retirement and plan to cut your portfolio's risk by shifting a sizable part of it into income investments. You may do well to hold off until the lowest tax rates kick in or to make the shift in several steps rather than all at once. Or else consider switching to tax-exempt bonds next year and replacing them with taxable issues after 2005. In that case, buy munis with short maturities, because compared with longer-term ones, their resale value will likely dip less due to declining tax rates.

Bone up on new education tax benefits

The cost of higher education has increased about five times as rapidly as median household income. To help you swim against this awesome tide, the new law markedly expands education saving choices and tax benefits. Most become available in 2002, so you can start early and magnify the rewards.

Many parents will find it simplest to set up education IRAs for their kids, even if the offspring aren't college bound. Couples with joint adjusted gross incomes under $190,000 may contribute $2,000 a year to an IRA for each child under 18 (up from $500). The age limit is waived for children who need more time to complete their education due to physical, mental, or emotional conditions.

Contributions aren't deductible, but earnings won't be taxed if used for college or for public or private elementary and high school costs, including tutoring fees and computer-related expenses. What's more, funds remaining in the IRA of a child who's through with school can be used for another family member's education expenses.

If you want to hedge against inflated higher education costs or you can afford to save more than $2,000 a year, you may find a prepaid tuition plan more desirable, because you can contribute up to $150,000 per child. From 2002 on, state-sponsored programs will offer tax benefits similar to education IRAs. After 2003, so will private ones.

You'll no longer be penalized if you contribute to both a prepaid plan and an education IRA for the same child in a given year. If you're currently limited in means, you can open an IRA and later participate in a prepaid plan. If you wish, you can withdraw funds from the IRA and use them to contribute to the plan. If you keep the IRA active until the time comes to pay the child's college costs, you can take tax-free distributions from it and from the plan in the same year, provided the total doesn't top covered expenses.

You'll have to act quickly to profit from another new education tax break. If your joint AGI is $130,000 or less, in 2002 and 2003 you can deduct up to $3,000 of the cost of any business-related college-level courses you take. In 2004 and 2005, the deductible amount will rise to $4,000, and joint filers with higher AGIs (no more than $160,000) will be able to deduct $2,000. After 2005, this tax break will disappear, unless Congress extends it.

If your joint AGI is $100,000 or less, existing law may allow you a Hope Scholarship or Lifetime Learning tax credit for some of the education expenses you, your spouse, or your dependents pay. However, you can't deduct the expenses and claim the credit in the same year for the same student. If you must choose between these two options, you're apt to benefit more from the credit, because it directly reduces your tax bill dollar for dollar. Be sure to crunch the numbers both ways, though.

The law contains especially good news for you if your student days are behind you but you're still paying interest on your education debts. Formerly, you could deduct student loan interest only during the first five years you were obligated to pay it, and the deductible amount was phased out if your joint AGI ranged from $60,000 to $75,000 ($40,000 to $55,000 for singles). Starting next year, the time limit disappears and the phase-out ranges become $100,000 to $130,000 (joint) and $50,000 to $65,000 (single), increasing with inflation in future years. The maximum annual interest deduction remains $2,500. If that's more than you're required to pay, consider making a voluntary payment so you can claim the full deduction. The new law permits it.

Added ways to pile on retirement savings

The new law jet-powers retirement savings. It lifts deductible contribution limits not only for pension plans but for IRAs. The present $2,000 cap on annual deductible IRA contributions will rise to $3,000 in 2002, or $3,500 for those 50 or older. By 2008, the limits will reach $5,000 and $6,000, respectively, and they'll be indexed for inflation thereafter. The same limits will apply to nondeductible contributions to a Roth IRA.

Even if you can't make a deductible contribution to a traditional IRA because you participate in a pension plan, your spouse can salt away the maximum if he or she doesn't work or isn't in a plan and your joint AGI is $150,000 or less. A spouse 50 or older could accumulate $31,000 in the next seven years, plus account earnings and tax savings on deductible contributions.

Retirement plan balances can grow at a far greater clip. Let's say your corporation pays you a $220,000 salary and makes the maximum allowable deductible contribution—15 percent of compensation up to $170,000—to your profit-sharing account. That comes to $25,500 for 2001. Next year, the 15 percent ratio can be raised to 25 percent and apply to $200,000 of compensation. That would boost the contribution to $50,000. However, there's an overall dollar limit on annual contributions. It's $35,000 this year, but the new law lifts it to $40,000 for 2002. So next year's contribution for you will be $40,000, not $50,000. Still, that's $14,500 more than the $25,500 you're getting for 2001.

Help is likewise on the way for doctors who participate in salary deferral plans. The 401(k) dollar limit on annual deferrals by employees under 50 will increase from $10,500 this year to $11,000 in 2002, then climb in $1,000 yearly steps to $15,000. (The limit is inflation-indexed after 2006.) If you're 50 or older, you can defer an extra $1,000 next year, $2,000 extra in 2003, and so on, to $5,000 in 2006 and later. So you can defer as much as $12,000 in 2002 and $20,000 in 2006. SIMPLE plan limits will also rise.

What if your employer contributes matching amounts to your 401(k) or to a separate profit-sharing plan account for you? A technical change in the new law will increase the total deductible contributions allowed on your behalf. Previously, salary amounts you deferred counted as employer contributions. From next year on, they'll no longer be treated as such, effectively raising the limit on deductions. The change also applies to other types of plans involving salary reductions, such as SIMPLEs.

In addition, the new law contains provisions intended to make it easier for plans to operate and to avoid penalties for discriminating against employees earning less than other plan participants. Practice owners will need to confer with their plan advisers regarding changes in their plan that should be made next year. That's especially important if your practice now has two plans, because the new, more generous contribution limits may make a second plan unnecessary.

If you don't have a plan now, the new law offers an incentive to get cracking. Beginning in 2002, you can claim a tax credit equal to 50 percent (or $500, if that's less) of a new plan's start-up costs in each of the first three years of operation. Start-up costs comprise expenses to establish and administer the plan and educate your employees about retirement planning. If you choose a 401(k), alone or in combination with a profit-sharing plan, you may want to consider giving participants an option to deposit salary deferrals in a Roth contribution program, which is similar to a Roth IRA. Sponsors of 401(k)s can allow this after 2005.

New reasons to overhaul your estate plan

The new tax law complicates estate planning beyond belief, but it doesn't scrap the unlimited marital deduction. That means your spouse still can inherit any amount free of federal tax. If you die later than 2010, your spouse won't owe federal estate tax, but he or she, along with your other heirs, will owe capital gains tax on assets you leave them, if those assets are sold for more than your cost. (Prior to 2010, decedents' assets will be stepped up to fair market value as of the date of death, as under previous law.) Even so, the new law provides that $1.3 million of the future gain won't be taxed, and your spouse will get an additional $3 million exemption.

This tax break will also be available to QTIP trusts, which pay the spouse all the income for life but give the principal to other beneficiaries after the spouse dies. So a surviving spouse can inherit at least $4.3 million free of all federal taxes, even if the new law stands as written.

Beware, however, if your present will includes a trust for your children or other beneficiaries that's designed to take advantage of the existing estate tax credit. You may need to revise it to assure that your spouse doesn't get less than you intended.

As you may know, if you die this year, heirs other than your spouse could receive up to $675,000 tax-free. The tax-sheltered amount ("exclusion") was scheduled to rise in stages, to a maximum of $1 million if death occurred after 2005. Under the new law, the $1 million exclusion will take effect in 2002, with further increases until it reaches $3.5 million in 2009. Depending on the wording of your will, some or all of that extra exclusion might end up in the tax-shelter trust instead of in your spouse's hands, if you die between 2002 and 2009.

For large estates, the beefed-up exclusion should be a boon, not a bane. If your spouse can live comfortably on a diminished share of your estate, the potential tax on his or her estate will be less. (Even if the federal tax is repealed, you may still have to contend with state tax.) Large estates will also benefit from the new law's scaled-down rates. The top estate tax rate will be trimmed from the current 55 percent to 45 percent after 2006.

Surprisingly, Congress decreed that lifetime gifts will remain taxable after the estate tax vanishes. Otherwise, the reasoning runs, high-bracket taxpayers would be free to slash taxes on total family income by shifting ownership of income-producing assets to relatives in lower brackets. This tactic will still be possible to some extent, though, thanks to a permanent $1 million lifetime gift tax exclusion. Also, the current annual exclusion for gifts up to $10,000 per recipient ($20,000 when made jointly with your spouse) is preserved.

Despite its complications and unresolved issues, the new law promises impressive tax savings, whatever your family and financial situation. For example, if you have a $2 million estate and your children inherit from you in 2005 rather than 2001, they'll save $335,200. On a $5 million legacy, they'd save more than half a million. That should make them extra glad to see more candles on your birthday cake.

A clouded sunset

The tax bill enacted earlier this year will expire completely after Dec. 31, 2010. This "sunset" provision was a parliamentary maneuver by the bill's supporters to prevent opponents from delaying the measure's passage. Legislation to nullify the sunset clause is anticipated.

Even if this doesn't pass, it's reasonable to assume that Congress will amend the sunset clause to exempt many key provisions in the act that have broad bipartisan backing. It's also likely that other sections of the act, notably those particularly favoring wealthy taxpayers, will in time be modified if not repealed outright. Financial planners will have to take these possibilities into account when making recommendations.

More tax breaks on the way

The accompanying article highlights the major features of the new tax law. Here are some other provisions that may put additional money into your pocket in years to come, if you qualify:

Child tax credit. This credit, formerly $500 for each child younger than 17 whose parents had joint AGIs of $110,000 or less, rises to $600 in 2001 through 2004, $700 in 2005 through 2008, $800 in 2009, and $1,000 in 2010.

Dependent care credit. Starting in 2003, a working couple whose joint AGI exceeds $43,000 can claim a credit of up to $600 for the cost of caring for one child under 13, or $1,200 for two or more. Currently, the credit maximums are $480 and $960, respectively.

Reduction in the "marriage penalty." Couples who choose the standard deduction instead of itemizing personal expenses now get less than twice the amount single taxpayers can claim. This disparity will gradually be eliminated between 2005 and 2009. (Married persons filing separately will enjoy quicker relief: Each can claim the same standard deduction as a single person, starting in 2005.)

Also, from 2005 through 2008, the amount of a couple's income taxed at 15 percent will increase to double the amount for singles. At present, it's only two-thirds more. No similar change is provided for higher brackets.

Unlimited itemized deductions. After 2009, you'll no longer have to reduce your personal deductions when your AGI is above a threshold amount. In 2001, for example, if your AGI exceeds $132,950, you must trim your total deductions by 3 percent of the excess. That AGI threshold will increase, and the reduction will decline to 2 percent in 2006, 1 percent in 2008, and zero in 2010.

Restored personal exemption. You'll lose part of your exemption total this year if your joint AGI exceeds $199,450. In 2006 and 2007, you'll lose only two-thirds as much; in 2008 and 2009, one-third; and in 2010, nothing. The AGI threshold will also increase.

 

Lawrence Farber. Make the most of the new tax law. Medical Economics 2001;18:22.