ECONOMIC GROWTH AND TAX RELIEF RECONCILIATION ACT OF 2001

INTRODUCTION

On June 7, 2001, President Bush signed the most sweeping tax cut legislation in 20 years, the "Economic Growth and Tax Relief Reconciliation Act of 2001." This legislation is far more than a simple tax cut bill. This mammoth tax bill contains 85 major provisions, 441 changes to the Internal Revenue Code, and almost 300 pages of text. In addition to providing the first cut in tax rates since 1986, the Act provides significant child-related tax relief, expands dramatically tax incentives for education expenses, phases out the estate and generation-skipping taxes, allows larger contributions to IRAs and other retirement plans, and provides significant marriage penalty tax relief. There is something in this tax package for just about everyone, including a $300 to $600 tax rebate.

The Act contains a laundry list of effective dates, ranging from retroactive treatment to effective dates 10 years down the road. Perhaps, the strangest aspect of this legislation is the sunset provision that was included to satisfy technical Senate budget requirements. Under the sunset provision, none of the changes made by the 2001 Act will apply to years beginning after 2010 unless Congress acts to extend the provisions of the Act.

This tax bill will have a major impact on tax planning for virtually every individual taxpayer (low income, middle income, and high income alike). For example, individuals may be able to reduce taxes by deferring certain expenditures into years when the new provisions are effective or by deferring income into years with lower tax rates.

CAUTION

As you read this letter, please pay special attention to the effective dates, which change from one provision to another. To help you, we have highlighted the effective date of each provision discussed. Furthermore, we offer planning ideas throughout the letter. However, you cannot properly evaluate a particular planning strategy without calculating your overall tax liability (including the alternative minimum tax) with and without that strategy. Please be careful! Call us before adopting any tax planning recommendation.

This letter is intended to be a brief summary of the 2001 Act provisions that we believe affect the largest number of our clients. Accordingly, we do not discuss some of the more technical provisions of the Act. Also, we have tried to explain the provisions covered in as few words as possible. If you are interested in a tax change that is not addressed here, or you want a more in-depth explanation of the Act, please call our office.

HIGHLIGHTS OF INCOME TAX RATE CUTS

Congress Cuts Tax Rates. This across-the-board cut in regular tax rates represents the crown jewel of the 2001 tax bill. This is the first cut in rates since 1986, and it represents over 60% of the cost of the entire $1.35 trillion tax package. Although President Bush originally proposed only four tax brackets, the new law (when fully phased in) will contain the following six tax brackets (up from 5 brackets under current law): 10%, 15%, 25%, 28%, 33%, and 35%. Caution! This rate cut is not immediate. Indeed, it will not be fully phased in until 2006. Planning Alert! The Act does not change the maximum tax rates for long-term capital gains.

10% Bracket Retroactive To January 1, 2001. To provide an economic stimulus, Congress made the new 10% tax bracket retroactive to January 1, 2001. The 10% rate will apply to the first $6,000 of taxable income for single filers, the first $10,000 for heads of households, and the first $12,000 for joint filers. The 15% rate will continue to apply to amounts in the "old" 15% rate bracket in excess of the amounts subject to the new 10% rate. Planning Alert! The new 10% rate does not apply to trusts or estates.

Tax Rebate Checks This Year. This retroactive rate cut means that for 2001, your taxes will be reduced by up to $300 if you file as single, up to $500 if you file as head of household, and up to $600 if you're married filing a joint return. If you filed a 2000 return, you should receive a notice from the IRS by this July indicating the amount of your rebate and when you can expect to receive it. The amount of the rebate is computed based on your 2000 tax return (not your 2001 return), even though it's actually a refund of 2001 taxes. If you filed your 2000 return by April 16, 2001, you'll be first in line to get your check and you should receive it by October 1, 2001. If you filed your 2000 return after April 16, 2001, you probably won't receive your check until later in 2001. Planning Alert! The rebate is available only to individuals, and will not go to estates, trusts, nonresident aliens, or dependents.

Other Rate Reductions. Effective July 1, 2001, the four top tax rates will be reduced. However, the rate reductions will not be fully phased in until 2006. The rates during the phase-in period are as follows:

28% Rate

31% Rate 36% Rate 39.6% Rate
Years Reduced To: Reduced To: Reduced To: Reduced To:

7/1/01-2003

27% 30% 35% 38.6%

2004-2005

26% 29% 34% 37.6%

2006 and later -------------------

25% 28% 33% 35.0%

New Law Eliminates Some Phase-Outs. Under current law, certain itemized deductions are reduced by 3% of your adjusted gross income (AGI) in excess of $132,950 ($66,475 if married filing separately). Also, your personal exemptions are reduced once your AGI exceeds $199,450 if you file a joint return ($132,950 if single). The good news is that Congress has repealed these phase-out rules. The bad news is the repeal is not immediate and does not even begin until 2006.

CHILD-RELATED TAX RELIEF

Child Tax Credit Increased. For 2000, you were allowed a $500 tax credit for each child under age 17 and the credit was reduced if your "modified adjusted gross income" on a joint return exceeded $110,000 ($75,000 if single). Generally, if your total child credits exceeded your entire income tax obligation, the excess was not refundable to you. However, if you had three or more children, the excess was refundable to you up to the amount your Social Security taxes exceeded your earned income tax credit.

· Effective after 2000, the new law increases the child credit as follows: 2001-2004 ($600 per child); 2005-2008 ($700 per child); 2009 ($800 per child); 2010 and thereafter ($1,000 per child). Furthermore, beginning in 2001, if your total child credits exceed your entire income tax obligation, you may be entitled to a refund of all or a portion of the excess -- regardless of the number of children you have.

Expansion Of Adoption Tax Credit. After 2001, the adoption credit (1) is increased to a maximum of $10,000 per child (including special needs children), (2) is made permanent (previously, it was a temporary credit except for special needs children), and (3) is not reduced by the alternative minimum tax. Under existing law, the credit is phased out if your modified adjusted gross income is between $75,000 and $115,000. Effective after 2001, the adoption credit is phased-out as your modified adjusted gross income increases from $150,000 to $190,000.

Expansion Of Dependent Care Credit. Effective after 2002, the Act increases the top dependent care credit rate from 30% to 35%, increases the maximum amount of eligible expenses from $2,400 to $3,000 for one child (from $4,800 to $6,000 if you have more than one qualifying child), and increases the beginning income phase-out level from $10,000 to $15,000 (the credit percentage is reduced to 20% once your adjusted gross income exceeds $43,000).

MARRIAGE PENALTY RELIEF

If you are married and file a joint return with your spouse, you may be paying more income tax than the total you and your spouse would have paid if you were each single. This so-called "marriage penalty" generally occurs when each spouse has significant income. The Act reduces but, unfortunately, does not eliminate the tax penalty for marriage. Also, most of these "relief" provisions do not begin until 2005. The following are several steps taken by the Act to reduce the marriage penalty:

Increased Standard Deduction For Married Taxpayers. Beginning in 2005, the basic standard deduction for married taxpayers will increase. Under current law, the basic standard deduction for a joint return is approximately 167% of the standard deduction for a single taxpayer. After 2004, the basic standard deduction for a joint return (as a percentage of the basic standard deduction for a single return) will increase as follows: 2005 (174%); 2006 (184%); 2007 (187%); 2008 (190%); and 2009 and thereafter (200%).

Married Taxpayers Will Have More Income Taxed At 15%. Beginning in 2005, married taxpayers filing joint returns will have a greater portion of their income taxed at 15%. Currently, the amount of income on a joint return taxed at the 15% tax rate is approximately 167% of the amount of income on a single taxpayer's return taxed at 15%. Beginning in 2005, the amount of income on a joint return taxed at 15% as a percentage of the amount taxed at 15% on single returns begins increasing. By 2008, the size of the 15% tax bracket for a joint return will be twice the size of the 15% tax bracket for a single person's return.

NEW TAX INCENTIVES FOR EDUCATION EXPENSES

In 1997, Congress created a host of new tax breaks for education expenses, including: the HOPE and lifetime learning credits (allowing tax credits for qualified tuition payments); Education IRAs (tax-favored IRAs used for qualified education expenses); tax-favored qualified state tuition programs; and a deduction for student loan interest. The Act expands and liberalizes (in some cases dramatically) the benefits of these tax breaks. If you are paying education expenses or saving for a student's education, you may benefit from these new rules. Most of these changes are effective after 2001.

Annual Education IRA Contribution Limit Increased From $500 to $2000. Currently, the earnings on funds placed in an education IRA escape taxation if the funds are used for qualified education. You can make nondeductible contributions to education IRAs up to $500 annually for each beneficiary. The Act increases the annual limit for contributions to education IRAs from $500 to $2,000 after 2001. This limit applies to the aggregate contributions that may be made by all contributors to one (or more) education IRAs established on behalf of any particular beneficiary.

Qualified Education Expense Definition Expanded. Distributions from an education IRA are tax-free only if used to pay for "qualified education expenses." Under current law, qualified education expenses are limited to qualified college and graduate school expenses. After 2001, you will be able to make tax-free distributions for payment of qualified education expenses to an elementary or secondary school as well as for payment of higher education expenses. This includes public, private, or religious schools (kindergarten through grade 12).

Phase-Out Limit Increased For Education IRAs. For 2001, your ability to contribute to an education IRA is phased out ratably as your modified adjusted gross income increases from $150,000 to $160,000 on a joint return (from $95,000 to $110,000 on a single return). After 2001, the income phase-out range for married taxpayers filing a joint return is from $190,000 to $220,000. Planning Alert! The income phase-out range for single taxpayers is not changed by the new law.

Qualified State Tuition Programs. Distributions from a "qualified state tuition program" will be tax-free if used to pay qualified education expenses after 2001.

Student Loan Interest Deduction Rules Relaxed. For 2001, you can deduct (whether or not you itemize deductions) up to $2,500 of interest on qualified student loans. You can only deduct interest paid during the first 60 months the interest payments are required and the deduction is phased out ratably as your modified adjusted gross income increases from $60,000 to $75,000 on a joint return (from $40,000 to $55,000 on a single return). The current rules do not allow you to deduct interest you voluntarily pay while the student loan is in a deferral or forbearance status. After 2001, the 60-month limitation is repealed and the interest can be deducted even if voluntarily paid while the loan is in deferral or forbearance status. Furthermore, the income phase-out ranges are increased to $100,000 - $130,000 on a joint return, and to $50,000 - $65,000 on a single return.

New Education Expense Deduction. The Act, after 2001, allows you to deduct (whether or not you itemize) up to $3,000 (for 2002 and 2003 increased to $4,000 in 2004 and 2005) of qualified education expenses in lieu of taking the HOPE or lifetime learning credits. You are not allowed this deduction if your adjusted gross income exceeds $130,000 on a joint return ($65,000 if single). However, for 2004 and 2005 if your adjusted gross income is between $130,000 and $160 000 on a joint return (between $65,000 and 80,000 on a single return), you are allowed a reduced deduction of $2,000. This education expense deduction is allowed only through 2005.

HIGHLIGHTS OF RETIREMENT SAVINGS AND PENSION REFORM

The Act includes pro-taxpayer changes to the qualified retirement plan rules. These changes impact regular IRAs, Roth IRAs, SIMPLE IRAs, 403(b) tax deferred annuities, section 457 plans and employer-sponsored retirement plans. The retirement plan changes in this new legislation are far too lengthy to discuss completely in this letter. We have included below the provisions we believe have the broadest impact.

Increased Contributions To Traditional And Roth IRAs. Currently, if you qualify, you may make a contribution to a traditional deductible IRA or to a nondeductible Roth IRA of up to $2,000 annually. After 2001, the maximum annual contribution to a traditional IRA or a Roth IRA increases as follows: 2002-2004 ($3,000); 2005-2007 ($4,000); 2008 and thereafter ($5,000). If you are age 50 by year-end, your maximum contribution is even higher: 2002-2004 ($3,500); 2005 ($4,500); 2006-2007 ($5,000); 2008 and thereafter ($6,000).

Increased Elective Deferrals For 401(k) Plans, Etc. For 2001, the maximum amount of compensation you can elect to put into a 401(k) plan, 403(b) plan, or salary reduction SEP (SARSEP) plan is $10,500. The maximum amount for a SIMPLE plan for 2001 is $6,500. For 2002, the maximum (except for SIMPLE plans) will increase to $11,000, and will continue to increase $1,000 each year thereafter until it reaches $15,000 in 2006. The maximum amount you can put into a SIMPLE plan in 2002 will increase to $7,000, and will continue to increase $1,000 each year thereafter until it reaches $10,000 in 2005. If you reach age 50 by the end of the tax year, the maximum elective deferral amounts are even larger.

New Credit For Elective Contributions. The Act creates a new tax credit for low and middle-income taxpayers who make elective contributions to qualified retirement plans. After 2001, qualifying taxpayers will generally be entitled to a tax credit of up to 50% of their elective contributions (up to $2,000) to a section 401(k) plan, section 403(b) plan, section 457 plan, SIMPLE plan, SEP plan, traditional IRA or Roth IRA. The credit is also available for employees' elective nondeductible contributions to qualified plans. The maximum credit is $1,000 (50% of $2,000).This 50% credit is phased out at certain income levels, and is phased out completely once adjusted gross income exceeds the following levels: joint return-$50,000; head of household-$37,500; all other filers-$25,000. Planning Alert! This is a temporary and non-refundable tax credit, which is scheduled to automatically terminate after 2006.

Contribution, Allocation And Benefit Limits Increased. For years beginning after 2001, the Act increases the maximum amount that can be allocated for any plan year to a plan participant's account in a qualified defined contribution plan (e.g., profit-sharing plan). The new limit is the lesser of 100% of compensation or $40,000 (previously $35,000). Also, the maximum deductible contribution to a defined contribution plan is increased to 25% of the compensation of employees covered under the plan. For years ending after 2001, the maximum annual benefit that can be provided for an employee retiring at age 65 in a defined benefit pension plan is the lesser of average compensation or $160,000 (previously $140,000). Several other changes were made to the rules for retirement plans that will generally increase their appeal.

REPEAL OF ESTATE AND GENERATION-SKIPPING TAXES (GIFT TAX REMAINS)

Along with tax rate cuts, another hallmark of President Bush's tax proposals was the repeal of the Federal estate and generation-skipping taxes. Although, under the Act, complete repeal is deferred until 2010, this still represents a monumental change in our Federal tax structure. Ultimately, the repeal of the estate tax and the generation-skipping tax will have a far-reaching ripple effect on tax planning strategies. In addition, the Act contains a laundry list of significant changes (generally pro taxpayer) to the existing estate, gift, and generation-skipping tax rules. The following is a summary of selected estate, gift and generation-skipping provisions of the Act:

Phase Out And Repeal Of The Estate Tax. The estate tax is repealed for 2010. Until then, we must deal with the existing estate and gift tax rules as modified by the Act. For 2001, you can transfer during your lifetime or at your death up to $675,000 free of any estate or gift tax. Furthermore, under current law, the highest estate and gift tax rate is 55% (before considering the 5% phase-out rule). The Act increases the amount of transfers that are exempt from estate taxes and decreases the highest estate and gift tax rates as follows:

Year Tax Rate Exemption Amount
2002 50% $1 million
2003 49% $1 million
2004 48% $1.5 million
2005 47% $1.5 million
2006 46% $2 million
2007 45% $2 million
2008 45% $2 million
2009 45% $3.5 million
2010 Estate Tax Repealed N/A

Caution! After 2010, the estate, gift and generation-skipping rules in effect before the Act will be reinstated under the Act's sunset rule absent Congressional action.
Gift Tax. The gift tax is retained even after 2009. The top gift tax rates will be the same as the maximum estate tax rates listed above from 2002 through 2009. After 2009, the top gift tax rate will drop to 35% (the maximum individual income tax rate). The maximum exclusion from gift taxes under the Act will be $1,000,000 after 2001. In other words, the amount exempt from gift tax is capped at $1,000,000 for 2002 and subsequent years even though the amount exempt from the estate tax continues to increase after 2003.

CAUTION

At this point, the only information we have regarding these new tax rules is the statutory language of the Act and the Congressional Committee Reports. Our interpretations of these new rules are based upon the information contained in these two documents. Additional clarifications will be issued later by the IRS in the form of regulations and other official pronouncements. Our firm will monitor these future developments.