By Joseph P. Nicola, Jr., JD, CPA
The new tax law has received great media attention lately, particularly as the deadline for the filing of 2001 income tax returns approaches. As such, the focus of attention has been on income taxes. However, the new law broadly affects physicians in a manner that is not limited to income taxes. The new tax law also creates tremendous savings and planning opportunities in the areas of education, retirement planning and estate planning. In this regard, a discussion of each, as well as the changes to the income tax laws is timely. The purpose of this article is to address these changes as a result.
As an initial matter, there are significant changes in the graduated rate system under which income is taxed. A new 10 percent tax rate will apply to a portion of income that was previously taxed at a rate of 15 percent. All taxpayers are entitled to the benefit of this new rate, which took effect in 2001 in the form of a federal tax rebate. In addition, beginning in 2001, all other tax rates will decrease at a rate of approximately one percent per year through 2006.
The alternative minimum tax has become a controversial subject recently, since it was originally designed to tax the wealthy. An increasing number of middle class taxpayers and children subject to the so-called “kiddie tax” have become exposed to the alternative minimum tax. In response, Congress has increased the minimum tax exemption under the alternative minimum tax system for 2001, which will continue to increase through 2004, reducing the exposure of all taxpayers to the alternative minimum tax system.
In the case of children, the child tax credit was increased under the new law beginning in 2001. The increase will ultimately reach $1,000 per child in 2010. Moreover, beginning in 2001, the credit is no longer reduced by the amount of any alternative minimum tax liability.
Finally, beginning in 2001, the adoption credit and the exclusion from income for employer-provided adoption assistance were permanently extended. Moreover, beginning in 2002, the maximum tax credit and the exclusion are increased to $10,000 per eligible child. Further, beginning in 2003, a taxpayer adopting a “special-needs child” is eligible for a $10,000 credit and an exclusion in the year the adoption is completed, regardless of the taxpayer’s qualified adoption expenses.
In recent years, the issue of education savings accounts for children has taken on increased significance, as the children of baby boomers approach college age. It is not a secret that most savings vehicles have numerous disadvantages. For example, most accounts created under an applicable Uniform Gifts to Minors Act are subject to limitations that prevent the creator of the account to withdraw funds. That is, such accounts typically become the legal property of the child upon the attainment of majority age, and the child is free to dispose of the account as he or she wishes.
In response, Congress enacted Section 529 of the Internal Revenue Code. Depending upon the state under whose law the account is created, Section 529 provides for tax-free growth on funds that are set aside for qualified education expenses. More important, distributions of funds for qualified education expenses made after 2001 are potentially federal income tax-free. As a general rule, all taxpayers are eligible to participate, regardless of their income levels. Note that this distinguishes the Section 529 account from other types of college savings vehicles, such as education IRAs, which are subject to such income limitations.
The new law also creates a new deduction for qualified higher education expenses. They are the same types of expenses that are permitted in determining the so-called “Hope Credit.” There are income limitations that restrict the ability to deduct qualified higher education expenses. Physicians should consult their tax advisors for these limitations.
Beginning in 2002, education IRAs will be permitted to be used for elementary and secondary school expenses. The maximum annual contribution rises from $500 to $2,000, while the phase-out range for joint filers will rise from $190,000 to $220,000, which is twice the amount for single filers.
The new law also makes permanent the exclusion for qualified employer-provided education expenses, and, beginning in 2002, the term “employer-provided education expenses” will include graduate courses as well.
Finally, beginning in 2002, student loan deductions will no longer be restricted to the first 60 months in which interest payments are due. In addition, the income limitations will change to the benefit of taxpayers.
Beginning in 2002, the maximum amount that an individual may contribute to a 401(k) plan is $11,000, and will ultimately increase to $15,000 by 2008. For taxpayers over the age of 50, the maximum amount for 2002 is $12,000, which will ultimately increase to $20,000.
The maximum amount that an individual may contribute to an individual retirement account will increase to $3,000 beginning in 2002. This amount will ultimately increase to $5,000 in 2008. For taxpayers over the age of 50, the maximum amount that an individual may contribute to an individual retirement account will increase to $3,500 in 2002, which will ultimately increase to $6,000.
For taxpayers who have created a SIMPLE Plan, the maximum contribution increases to $7,000 in 2002, and this will increase to $10,000 by 2008. For taxpayers over the age of 50, the limitation increases to $7,500 for 2002, ultimately increasing to $12,500.
The new law makes changes to other features relating to retirement plans as well. Beginning in 2002, the annual limitation on total contributions to a defined contribution plan will increase to $40,000 from $35,000. The benefit limit for a defined benefit plan will increase from $140,000 to $160,000. The limitation on compensation that may be taken into account under a qualified plan will increase to $200,000. This amount will be indexed for inflation.
Perhaps the most significant change under the new law is the phase-out of the estate and generation-skipping transfer taxes. As a general proposition, the estate and generation-skipping transfer taxes begin to decrease in 2002 until they are eliminated in 2010. Beginning in 2002, the gift tax transfer exemption will increase to $1 million. In addition, the highest gift tax rate will decrease to 50 percent. This rate will ultimately decrease to a rate of 35 percent by 2010.
The estate and generation-skipping transfer tax exemption also increases in 2002 to $1 million. By 2009, the exemption will increase to $3,500,000. In 2010, the estate and generation-skipping transfer taxes will be eliminated. In addition, the highest estate and generation-skipping transfer tax rates will decrease to 50 percent in 2002, ultimately dropping to 45 percent in 2009, before being eliminated in 2010.
It is apparent from the foregoing that the well-advised physician should take advantage of these and the numerous other changes that have been enacted by Congress. Proper planning can mitigate the harsh impact of income, estate and gift taxes, while preserving wealth for retirement and other family members.
Joseph P. Nicola, Jr., JD, CPA is a shareholder with Alpern, Rosenthal & Company in Pittsburgh. Pa.