THE JOBS AND GROWTH TAX RELIEF RECONCILIATION ACT:
How It Will Affect You and What To Do About It
The recent changes in tax law offer benefits to many different classes of taxpayers. However, they are complex and should be analyzed carefully to take full advantage of the tax-saving opportunities.
The Jobs and Growth Tax Relief Reconciliation Act provides some tax relief to virtually every individual income taxpayer. Taxes on wages and small business income have been reduced. Changes in the taxation of capital gains and dividend income are encouraging investors—including those investing through IRAs, 401(k)s and Keogh plans—to change investment policies. Indeed, some major financial decisions, generally requiring professional advice, need to be made.
The recent tax law update is mostly about cuts in individual income tax rates, and is temporary. The cuts will first show up in reduced wage withholding.
|
Note: Most taxpayers qualifying for the child tax credit will receive refund checks. |
When individual tax rates are cut, those paying the most income taxes derive the greatest benefit. That principle is also at work in new tax cuts that specifically target capital gains and dividend income. Benefits targeted for families increase the child credit and ease the “marriage penalty.”
For businesses, there are expanded writeoffs on equipment purchases, bonus depreciation for other equipment (including new cars used in business), and a modest postponement in corporate estimated tax payments.
These cuts and other changes—legally and technically, at least for now—are generally to end at varying times from 2004 to 2010 under the “sunset” rules.
|
Note: A “sunset” is Washington jargon for a provision that expires at a specified future date. Provisions in the first Bush tax cut in 2001 were written to sunset at the end of 2010. These 2001 sunset provisions remain. The Jobs and Growth Tax Relief Reconciliation Act tax law provisions generally sunset much earlier than 2010. The tax law sunset has a purpose. In this era of large current and predicted future budget deficits, the tax cuts in the Jobs and Growth Tax Relief Reconciliation Act tax law won passage largely because they were presented as temporary stimuli to economic activity. The problems caused by sunset provisions are widely recognized. They cause uncertainty in long-term planning (especially investment and corporate finance planning based on the tax law’s dividend changes). |
GENERAL RATE CUTS
The Jobs and Growth Tax Relief Reconciliation Act tax law rate cuts are best understood by recalling what the 2001 tax law did. Just before that Act was enacted, individual rates were 15%, 27%, 31%, 36%, and 39.6%. The 2001 tax law scheduled reductions in all rates above 15%, effective over the period 2001–2010, and added a 10% rate.
10% rate . The 2001 tax law introduced a 10% rate for the lowest level of taxable income (up to $6,000 for singles or marrieds filing separately and $12,000 on joint returns). The 10% rate replaced the 15% rate at those income levels. The five percentage point rate reduction, effective in 2001, was why IRS sent out all those $300 and $600 instant refund checks during 2001 (5% of $6,000 is $300). The 15% rate (and higher rates) applied to taxable incomes above that level.
Under the 2001 rules, the 10% rate was to apply to the first $7,000 ($14,000 on a joint return) in 2008. The 2003 tax law accelerates this, so that the 10% rate applies to the first $7,000 ($14,000) this year, 2003.
|
Example: A single individual with taxable income of $7,000 or over in 2003 saves $50 from this change (5% of $1,000). A joint return with taxable income of $14,000 or over saves $100 (5% of $2,000). |
The 15% rate (and higher rates) apply to taxable incomes above this level.
For 2004, the 10% rate levels ($7,000/$14,000) are adjusted for inflation. For 2005 and after, the 2001 tax provisions resume, with the 10% rate dropping back to taxable income up to $6,000/$12,000 until 2008.
Other rate cuts . In the 2001 tax law, rates above 15% were to trail down periodically over the years 2001-2006 from 28%, 31%, 36% and 39.6% to 25%, 28%, 33% and 35%, respectively.
The Jobs and Growth Tax Relief Reconciliation Act tax law update makes these 2006 rates effective for 2003 through 2010, i.e., the 2010 sunset from the 2001 tax law will apply but there is no tax law sunset within that. The rates 25%, 28%, 33% and 35% replace those previously scheduled rates of 27%, 30%, 35% and 38.6%, respectively.
There is, in effect, a further tax rate cut for joint return filers. The marriage penalty provision (see below) expands the amount of income subject to the15% rate on joint returns, thereby (for this group) taxing at 15% some income otherwise taxable at 25%. This benefits all marrieds filing jointly whose income would otherwise be taxable at rates higher than 15%.
Deduction phaseouts unchanged . The current tax law reduces deductions for personal and dependency exemptions and for itemized deductions in the upper tax brackets. When this device, called a “deduction phaseout,” was introduced, it was in lieu of increasing tax rates in those brackets: Instead of increasing the tax rate, Congress increased the amount subject to tax (by reducing deductions otherwise allowed).
The 2001 tax law reduces this phaseout over 2006-2009, bringing it to zero (eliminating the in-lieu-of-rate-increase) in 2010. The recent tax law update does not accelerate this schedule, so that its new rate reductions to rates of 28% and higher are less than fully effective.
RATE CUTS ON INVESTMENT INCOME
Capital gains . Prior to the Jobs and Growth Tax Relief Reconciliation Act tax law (2003), there was a basic 20% rate on long-term capital gains (gains on assets held more than a year), and a variety of special rates, some higher than 20% and some lower. For lower-income taxpayers — specifically, those in the 15% rate or lower bracket — the capital gain rate was 10%. Relief applied for property held more than five years, which reduced the 10% rate to 8% and (for property acquired or treated as acquired after 2000 and held more than 5 years) the 20% rate was reduced to 18%. For certain special items, such as depreciable real property, the rate was 25% or 28%.
The Jobs and Growth Tax Relief Reconciliation Act tax law takes these complexities to a new level. Effective for sales after May 5, 2003, the 20% rate becomes 15% and the 10% rate (for lower-income taxpayers) becomes 5% (and zero in 2008). These rates also apply for alternative minimum tax (AMT) purposes. In other words, there are two sets of rules in 2003, depending on when the property is sold. Exception: There’s no change on rates for property taxed at 25% or 28%.
The five-year-property rule, with its 8% and 18% rates, is repealed. The new 5% (zero in 2008) and 15% rates, and the repeal of the higher and now useless 8% and 18% rates, are effective for sales after May 5, 2003 in years ending before 2009, after which the previous rules are reinstated absent further legislation.
|
Note: No one could qualify for the five-year,18% rate in 2003 since property had to be held until 2006. But a gimmick in the five-year rule let taxpayers report and pay tax on appreciation up to 2001 so that future appreciation could qualify for the 18% rate on sales after 2005. The 2003 tax law does not provide for refund of tax paid in 2001 to qualify for lower rates later. |
|
TIP: Taxpayers converting traditional IRAs to Roth IRAs are paying a substantial tax now to get future tax relief. It may be wise to review conversion plans with your tax advisor, in light of what happened with five-year-capital-gain relief (no refund of tax paid for future relief which proved unnecessary). |
Dividend tax relief . The 2003 tax law sharply reduces the individual income tax on dividends from domestic and certain foreign corporations, i.e., on “qualified dividends” (see below). Effective for dividends received after 2002 and before 2009, dividends will be taxed, for income and AMT purposes, at 15%, except at 5% (zero in 2008) for lower-income taxpayers (those otherwise in the 15% or lower bracket).
As you may have noticed, these rates are the same as those for long-term capital gains on sales after May 5, 2003, and dividends and capital gains will be combined in the tax reporting of those who have both.
|
Note: Excluded from the new relief are: “in lieu of” dividends on stock involved in short sales; dividends on stock held for less than 61 days during the 120-day period starting 60 days before the ex-dividend date; and dividends in certain other special situations. Dividends from mutual funds are generally qualified dividends if they are passing through such dividends. Dividends from foreign corporations are qualified where their stock or ADRs are traded on U.S. exchanges or with IRS approval where the dividends are covered by U.S. tax treaties. |
Dividend reporting from corporation to stockholder will specify the portion qualifying for tax relief—a burden imposed on the dividend payer, which does not directly benefit from the new rule. However, the corporation is affected in other ways, viz., it can deduct interest paid on debt financing but not dividends paid in equity financing.
|
Note: Some consider this encourages corporations to unduly favor debt, though there is no consensus that U.S. corporations generally are overloaded with debt. Since dividends will now (before the sunset) be taxed at rates lower than interest, some believe that corporations will shift towards more equity financing and that stockholders will pressure corporations for more dividend distributions. |
|
Note: The economic consequences of dividend tax relief were intended by some promoters of the change. They (or some of them) wanted a tax provision (dividend tax relief) tending to boost the stock market. They (or some) wanted a tax provision to encourage more equity funding and less borrowing. A major consideration, for business owners and investors, is whether this dividend tax relief, offered as a temporary stimulus, will endure. Past dividend tax relief, in the form of a tax credit for dividends, was repealed (in 1964). Other countries that grant relief from corporate double tax do so in ways that differ from that in the 2003 tax law, viz., by allowing corporations to deduct dividends paid or by increasing the individual’s dividend by related corporate tax paid and allowing the individual a tax credit for that tax. |
Reviewing your investments . Dividend income is now more lightly taxed than such other investment income as interest on debt, most REIT distributions, and distributions from annuities, including variable annuities based on stock investment.
|
TIP: You should consider balancing your portfolio in favor of more equity investments. For IRA, 401(k) and Keogh investors, putting interest-bearing investments in these tax-sheltered accounts may be favored, since they aren’t currently taxed. And individual stockholders may want to pressure their corporations to increase dividend payouts. |
ALTERNATIVE MINIMUM TAX (AMT) RELIEF
The AMT is a complex federal tax system that runs parallel to the regular federal income tax. It applies when tax under that system is higher than the regular federal income tax — in which case the taxpayer pays the larger amount. The number and proportion of middle- and upper-middle-income taxpayers hit by AMT has been increasing annually. For example, more-or-less middle-income taxpayers with large families (large dependency exemptions) have been hit, as have middle-income taxpayers with large gains subject to state income taxes.
|
Note: Dependency exemptions and state income taxes aren’t deductible for AMT. |
 |
Note: This trend was accelerated by the 2001 tax law, whose tax reductions increase the cases where AMT taxes are higher than the regular income tax. Thus, a number of taxpayers find that their taxes have not enjoyed the full relief expected from the 2001 tax law. Although there is modest temporary AMT relief in the 2003 tax law, the overall trend continues of increasing the number of individuals subject to AMT. |
A basic exemption amount applies in figuring AMT, an amount which phases out as AMT-taxable income rises. For 2003 and 2004, that exemption amount increases by $8,000 (up to $57,000) for marrieds filing jointly and by $4,500 (up to $40,250) for singles.
There is also, in a sense, AMT relief in the fact that the 2003 tax law rates for capital gains and dividends are the same for regular income tax and for AMT. Tax rate cuts for these items won’t contribute to an AMT higher than the regular income tax.
|
Note: On the other hand, the 2003 tax law’s benefits of the lower general rates, and the child credits, can overcome the value of the exemption increases, adding to the number of AMT taxpayers. |
|
TIP: The AMT tax bite can sometimes be relieved through planning, e.g., planning the timing of state estimated income tax payments. |
FAMILY TAX CUTS
Child credit . Under the 2001 tax law, the child credit for taxpayers with children under age 17 increases periodically from $600 per child in 2003 to $1,000 per child in 2010. The 2003 tax law accelerated the increase to $1,000 for each child for 2003 and 2004, after which the rate reverts to the 2001 tax law scheduled rate ($700 in 2005). As under the 2001 tax law, the credit for 2003 and 2004 phases out—is reduced or eliminated—as adjusted gross incomes rise above $75,000 (singles and marrieds filing separately) and $110,000 (joint returns).
The child credit is partly refundable—that is, payable to low-income individuals with no income tax liability. The refundable part is scheduled under the 2001 tax law to increase in 2005; the 2003 tax law did not accelerate that.
Marriage penalty relief . A marriage tax “penalty” occurs when the tax on a couple’s combined incomes on a joint return is higher than the sum of what the taxes would be on their separate incomes as single individuals. This penalty arises when the combined incomes are taxed in a higher bracket than their incomes as single individuals. A marriage tax “bonus,” a slightly more common case, occurs when taxes on the combined incomes are less, i.e., where combining incomes brings down the tax bracket that applies to the higher earner as an individual.
The 2001 tax law attacked the marriage penalty in a modest way: No action until 2005, then a gradual increase from 2005 to 2009 in the standard deduction on a joint return, and an expansion of the 15% bracket on a joint return from 2005 to 2008.
The end result—making the standard deduction for married couples, and the incomes covered by the 15% bracket, twice that for singles—eliminates the marriage penalty (as defined above) for that population (and for some in the 25% bracket), generally the lower-income ranges.
The 2003 tax law accelerated this end result to 2003 and 2004 only, after which the schedule in the 2001 tax law begins. Thus, the standard deduction on a joint return for 2003 is $9,500 (as compared to $7,950 without this change) and the 15% bracket on a 2003 joint return is for taxable income above $14,000 but not more than $56,800 (as compared to $12,000/$47,450 without this change, and without the $2,000 increase in the 10% bracket explained under “10% rate” above).
|
Note: This way of identifying a marriage “penalty” assumes that two individuals would have the identical individual and family items as a married couple that they had when single. It ignores that tax is applied to “taxable income,” a concept that incorporates a range of income and deduction rules, including rules (such as those on IRA and pension distributions and on personal residences) that exist only for married persons. Even as a purely tax rate measure, the legislation makes no changes in the brackets above 15%. |
BUSINESS TAX CUTS
Expensing equipment costs . Businesses generally, including unincorporated businesses, may elect to expense (deduct immediately) the cost of most new business equipment up to a fixed annual amount, instead of deducting the cost through depreciation deductions over a period of years.
Before the 2003 tax law, expensing was allowed for up to $25,000 of new equipment, except the $25,000 allowance was reduced dollar-for-dollar by the amount by which purchases of such equipment exceeded $200,000. The 2003 tax law increases that $25,000 to $100,000, reduced dollar-for-dollar by the amount by which purchases of such equipment exceed $400,000. The $100,000 limit applies for purchases in taxable years beginning after 2002 and before 2006, with the $100,000/$400,000 figures indexed for inflation in taxable years beginning after 2003 and before 2006. The $100,000 rate sunsets thereafter, reverting to the $25,000/$200,000 rule.
The 2003 tax law continues the previous rule that the expense deduction can’t exceed the year’s taxable income but the excess can be carried over and deducted in later years.
Bonus depreciation . New business equipment that is not expensed (for example, equipment in excess of the expensing allowance or where expensing isn’t claimed) can qualify for bonus first-year depreciation. Bonus depreciation was enacted because of 9/11 and its consequences, and was originally 30% of the cost of the new equipment. The 2003 tax law raised that 30% to 50% for equipment bought new and first put into service after May 5, 2003 (assuming there was no binding contract to buy before then) and before 2005 (2006 for certain long-lived property). The 50%-of-cost amount may be taken in full in the first year and need not be prorated for the part of the year the property was in service. Regular depreciation, computed on the cost minus the 50% depreciation, is also allowed for the year.
Taxpayers may elect 30% depreciation, instead of 50%, or no bonus depreciation.
|
TIP: Consider electing 30% or no bonus depreciation if you wish to absorb an expiring net operating loss carryover or to push more depreciation into a future year when you expect to be otherwise in a higher tax bracket. |
New car purchases . New cars used more than 50% for business benefit to a degree from bonus depreciation, discussed above. Changes in response to 9/11 allowed a special increase in first-year depreciation up to $4,600 (on top of a “regular” first-year allowance which was $3,060 in 2002). The 2003 tax law increases the $4,600 figure to $7,650 for cars bought new and first put into service after May 5, 2003 and before 2005, which will be on top of regular first year depreciation.
STATE TAX IMPACT
Most state income tax on individuals more or less follows the federal system, using federal definitions of taxable or adjusted gross income. Thus, the new federal rules on expensing and depreciation would lead to some reduction in state tax as well, assuming the state systems accepted the changes. State tax reduction would also happen in states that apply the increased federal standard deduction on joint returns.
Since states set their own tax rates, changes in federal rates generally are not reflected in the states. Thus, the new capital gains and dividend tax benefits, which are targeted tax rate changes, generally do not pass through to states.
|
Note: Where state tax relief does not match federal relief, that pushes up state taxes relative to federal taxes. Since state income taxes are not deductible for federal AMT purposes, that tends to increase AMT liability. |
|
Note: Even where states generally follow the federal rules, they have the legislative power to depart from them. |
2003 TAX CUT EXAMPLES
Here are examples showing 2003 individual income tax cuts at varying levels of taxable income. AMT and special rates for capital gains and dividends are disregarded. Child credits, where available, reduce taxes still further.
Type of Taxpayer |
Taxable Income |
New Tax |
Old Tax |
Tax Savings |
Single |
$40,000 |
$6,810 |
$7,092 |
$282 |
Single |
$60,000 |
$11,810 |
$12,492 |
$682 |
Single |
$96,000 |
$21,626 |
$23,028 |
$1,402 |
Married, joint return |
$80,000 |
$13,620 |
$15,306 |
$1,686 1 |
Married, joint return |
$120,000 |
$23,781 |
$26,267 |
$2,486 2 |
Married, joint return |
$250,000 |
$63,946 |
$69,032 |
$5,086 |
Note 1: This taxable income is twice that for the single individual in Example (1), and the tax is exactly double. Thus, where marriage penalty is defined solely in terms of rates (disregarding the composition of taxable income), there is no marriage penalty at this level where two individuals have the same (viz., $40,000) taxable income. In each case all income in excess of the 15% rate is taxed at the same rate (25%).
Note 2: This taxable income is twice that for the single individual in Example (2), but there is a marriage penalty (where rates alone are considered). Tax on the couple is more than twice that of two individuals with identical taxable incomes (of $60,000) because the couple, unlike the single individuals, has some income subject to the 28% rate.
