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Income Tax Rate Reductions
Our federal income tax rate structure uses graduated tax rates to impose a higher rate of tax as your income rises. For higher-income taxpayers, the new law changes provide some rate reduction relief (low- and moderate-income taxpayers do not experience any rate relief at this time).
This chapter explains how the income tax rates decline for 2002 and what you can do to take advantage of the changes. You will also learn about the multiple capital gains tax rates in effect for 2002. And you will find out about the alternative minimum tax (AMT)--what it is, whether it applies to you, the changes for 2002, and what you can do to avoid or reduce this tax.
General income-shifting strategies are provided to enable you to redistribute wealth within your family in order to save income taxes. Finally, special coverage is given to adjusted gross income (AGI)--the measuring rod for determining eligibility for many of the tax breaks discussed throughout this book--and what you can do to control your AGI in order to increase your eligibility for these tax opportunities.
Income Tax Rates
For 2002, you'll probably pay less income tax than you would have paid in 2001 (if your income is about the same in both years). The simple reason is that the federal income tax rates are lower in 2002. But the complete reason is more complex.
For 2002, there are six individual federal income tax brackets: 10 percent, 15 percent, 27 percent, 30 percent, 35 percent, and 38.6 percent. The two lowest tax brackets (10 percent and 15 percent) are the same as they were in 2001--they are unchanged by the newlaw. The four highest tax brackets, however, have each been reduced by one-half of one percentage point (they were 27.5 percent, 30.5 percent, 35.5 percent and 39.1 percent respectively in 2001).
Unlike 2001, there is no rebate check for the 10 percent bracket. The lowest tax bracket is, however, reflected in the 2002 tables that employers use to figure income tax withholding on wages to employees, so if you're subject to wage withholding, the benefit from the 10 percent rate has been taken into account throughout the year.
In addition to a reduction in rates, all of the tax brackets except the 10 percent bracket have been adjusted for inflation. So you can earn more income in 2002 without being pushed into a higher tax bracket.
Any tax planning you undertake depends on your personal situation. However, the following generalities provide some guidance for taking advantage of changes in the tax rates.
INCOME DEFERRAL. Shifting income from the current year into a future year saves you money because it postpones the time in which you pay the tax on the income. For example, if you receive income in December 2002, you owe the tax on that income by April 15, 2003. But if you defer that income for one month--to January 2003--you don't owe the tax until April 15, 2004.
But tax postponement isn't the main incentive for income deferral. Because of cost-of-living adjustments to the 15 percent, 27 percent, 30 percent, 35 percent, and 38.6 percent tax brackets, income shifted from 2002 into 2003 may be taxed at a lower rate. This translates into a real tax savings. Whether income deferral produces this result depends on whether that income falls into a lower tax bracket.
How do you defer income into a later year? There are several proven strategies you can use to shift income from 2002 into 2003.
Make investments that pay income after December 31, 2002. For example, after June 30 you invest in a six-month certificate of deposit coming due after the end of the year. Interest is not considered to have been received on this CD until 2003. Similar results can be obtained with three-month and six-month Treasury bills that come due after the end of 2002.
Self-employed individuals on the cash method of reporting their income and expenses can delay year-end billing so that accounts receivable for work performed in 2002 or goods sold in 2002 will be paid in 2003. Of course this deferral strategy is not advisable where there is any concern about collecting the accounts receivable--in such a case it's better to bill and collect as soon as possible.
Longer deferral may prove even more advantageous because the tax rates above the 15 percent bracket are scheduled to decline again in 2004 and again in 2006. So income shifted from 2002 into these later years may be taxed at even lower rates, irrespective of cost-of-living adjustments that will continue to be made. There are also several reliable strategies you can use to defer income from 2002 until several years into the future.
Make contributions to tax-deferred accounts such as 401( k) plans, 403( b) annuities, 457 plans, deductible individual retirement accounts (IRAs), and commercial annuities. You may find yourself in a lower tax bracket when funds are withdrawn later on than you are now.
Arrange for deferred compensation. Your employer may be willing to defer the payment of a year-end bonus or a percentage of your salary until you leave the company (typically upon retirement). Again, at that time you may find yourself in a lower tax bracket than you are in 2002. Generally, the deferred compensation arrangement must be entered into before the income is earned.
DEDUCTION ACCELERATION. The flip side to deferring income is accelerating deductions into 2002 that might otherwise be taken in 2003 if you expect to be in a lower tax bracket in 2003 than in 2002. This is because deductions are worth more as tax brackets are higher.
Here are some strategies you can use to accelerate into 2002 deductions you might otherwise have taken in 2003:
Make discretionary expenditures--elective medical procedures that are not reimbursed by insurance and which are deductible (e.g., additional prescription sunglasses) and charitable contributions. For instance, if you've pledged this year to contribute $1,000 a year for five years to your alma mater, you may wish to satisfy that pledge in full in 2002 when the deduction for this charitable contribution is worth more than if you fulfill the pledge in 2003, 2004, 2005, and 2006.
Prepay state and local income and real estate taxes. For example, state and local tax payments due in January 2003 can be paid in December 2002 so they become deductible in 2002. Be careful: Don't prepay these taxes if you're subject to the alternative minimum tax (AMT) (explained later in this chapter); you can't deduct these taxes for AMT so you lose the tax benefit of the prepayment.
If you have a self-employed business on the cash method of accounting, prepay certain expenses that can be deducted this year. For instance, stock up on supplies and pay off all outstanding bills for deductible items before the end of the year. Be careful: Don't prepay multiyear items (e.g., three-year subscriptions or multiyear insurance premiums) since they are deductible only over the period to which they relate.
Capital Gains Rates
The capital gains tax rates have not been changed in any way for 2002. There are still about a dozen different capital gains rates to contend with. The applicable rate can depend on the type of assets you own, how long you've held them, and the income tax bracket you're in for the year in which you sell the assets.
IF YOU'RE IN THE 10 PERCENT OR 15 PERCENT TAX BRACKET. The general rate on long-term capital gains--gains from the disposition of capital assets held more than one year--is 10 percent. For assets held more than five years, the rate drops to just 8 percent. These rates apply regardless of the type of capital asset involved.
IF YOU'RE IN A TAX BRACKET ABOVE 15 PERCENT. The general rate on long-term capital gains is 20 percent (including assets held more than five years). For those in tax brackets above the 15 percent rate, there are other capital gains rates that may apply. These include:
The 25 percent rate on unrecaptured depreciation. This is all of straight-line depreciation on real estate other than a principal residence and all straight-line depreciation after May 6, 1987, on a principal residence (for example, on the portion of a residence used as a home office).
The 28 percent rate on collectibles gains and gains on certain small business stock (called Section 1202 gains). However, those in the 27 percent tax bracket may pay only 27 percent, not 28 percent, on these gains.
The 18 percent rate on gains from assets acquired after December 31, 2000, and held more than five years. This rate also applies to assets held at the start of 2001 for which you elected on your 2001 return to report as a "deemed sale." You reported the gain to January 1, 2001 (January 2, 2001, in the case of publicly traded securities) that would have resulted had you actually sold the asset and revised your tax cost basis and holding period to reflect this action. Whether you have new assets or assets reported as a deemed sale, the five-year post-2000 holding period means that the low rate does not come into use until 2006.
Alternative Minimum Tax Rates
The alternative minimum tax (AMT) is a shadow tax system designed to ensure that all individuals with income above a certain amount--even those with substantial write-offs (other than tax credits)--pay at least some federal income tax. Unlike the tax brackets for the regular income tax, the two AMT rates of 26 percent and 28 percent are not indexed annually for inflation.
EXEMPTION AMOUNT. Only alternative minimum taxable income--your taxable income for regular tax purposes adjusted by special tax preferences and other adjustment items--above a certain amount is subject to the AMT. This threshold is determined by your AMT exemption amount. The AMT exemption amount (increased in 2001) remains unchanged for 2002. (The increase to the exemption amount is temporary and applies only through 2004.)
For a child under age 14 who is subject to the kiddie tax on unearned income, there is a special AMT exemption. This exemption is higher in 2002 than it was in 2001. The child's AMT exemption amount in 2002 is limited to $5,500 plus any earned income. However, the child's AMT exemption amount cannot exceed the exemption amount for a single individual--$35,750.
TAX CREDITS. Even if you do wind up with a tentative AMT liability, you may not have to pay it. This liability can be offset by certain tax credits. The earned income credit is no longer reduced by the alternative minimum tax. Also, personal tax credits (e.g., the child tax credit, education credits, the dependent care credit, and the adoption credit) can be used to offset both the regular tax and the AMT. As in the past, AMT liability may also be offset by the foreign tax credit.
In order to plan effectively to minimize or avoid the AMT, you must understand how this alternative tax system works. Certain write-offs allowed for regular tax purposes can't be used in figuring AMT. And certain income items that were not subject to regular tax are now taxable for AMT purposes.
DEDUCTION PLANNING. For AMT purposes, no deduction is allowed for state and local income taxes. This means that accelerating state and local income tax payments to boost regular tax deductions for the year may prove meaningless if it triggers or increases AMT. Before making any year-end payments of state and local income or property taxes otherwise due in January of next year, consider the impact that this prepayment will have on AMT.
For AMT purposes, no deduction is allowed for miscellaneous itemized deductions. If you have substantial legal expenses, unreimbursed employee business expenses, investment expenses, or other miscellaneous expenses, you lose the benefit of their deduction for regular tax purposes if they trigger or increase AMT. To avoid this result, it may be helpful to minimize your miscellaneous deductions.
When retaining an attorney for a legal action involving a contingency fee, be sure that the arrangement creates an interest for the attorney in the recovery so that you need only report any net recovery (the amount you receive after the attorney receives his or her share). If you do not, or if state law does not create such an interest, then you must report the recovery in full and claim any legal fees as a miscellaneous itemized deduction for regular income tax purposes (but not for AMT purposes).
Request that your employer use an accountable plan to cover employee business expenses. Under an accountable plan, employer advances or reimbursements for travel and entertainment costs are not treated as income to you; you must substantiate your business expenses to your employer and return any excess reimbursements. In contrast, if your employer has a nonaccountable plan, employer reimbursements for your business expenses are treated as additional income to you. Then you can deduct your business expenses, but only as a miscellaneous itemized deduction. Such expenses become deductible only to the extent that the total exceeds 2 percent of your adjusted gross income. And this itemized deduction is not allowable for alternative minimum tax (AMT) purposes, which may result in triggering or increasing AMT.
Another write-off for regular tax purposes that can't be claimed for AMT purposes is the deduction for personal exemptions. It may be advisable in appropriate circumstances to waive the dependency exemption. Since personal exemptions are not deductible for AMT purposes, even middle-income taxpayers with a substantial number of dependents may fall victim to the AMT.
INCENTIVE STOCK OPTION PLANNING. If you hold incentive stock options (ISOs), which give you the right to buy a set number of shares of your employer's stock at a set price within a set time, exercising them does not produce any income for regular tax purposes. But the spread between the option price and stock price on the date the ISOs are exercised is an adjustment to alternative minimum taxable income. In effect, even though the exercise of ISOs does not produce any regular income tax consequences, such action may trigger AMT. Thus, it is important to time carefully the exercise of ISOs to avoid the AMT.
Generally it is advisable to spread the exercise of ISOs over a number of years rather than exercising them all at once. This will minimize any adverse tax impact.
But tax considerations may have to take a backseat to other factors. Watch out for expiration dates on the options. Also consider moves in the stock prices and the availability of cash to exercise the options.
One intrafamily tax-saving strategy is to shift income from someone in a higher tax bracket to someone in a lower tax bracket. In this way, the income remains in the family but the tax bite is reduced. In the past, when top tax rates were higher, the tax savings from income shifting were more dramatic. But even with today's reduced tax rates, there can still be considerable tax savings for the family.
Income shifting can also produce substantial savings if capital gains producing property can be shifted from a family member in a higher tax bracket to one in a lower bracket.
Strategies for Income Shifting
Income can be shifted from a higher tax bracket family member to one in a lower bracket by giving income-producing property. (The rules on making tax-free gifts in 2002 are discussed in Chapter 4.) Here are some types of property to consider giving away for income-shifting purposes:
- Cash that can be invested in income-producing property.
- Dividend-paying stocks.
- Corporate bonds and Treasury securities.
- Stock and shares in mutual funds with unrealized capital gain.
- Interests in an S corporation, limited liability company, or partnership owned by the parent or grandparent.
- Doing so means that the child's share of the entity's income passes through to the child and is taxed at the child's lower tax rate.
BASIS. Remember that when property is gifted, the recipient generally takes over the same tax basis and holding period as the donor. The precise rules on basis depend on whether the recipient sells the property at a gain or a loss and whether you paid any gift tax when you made the gift.
Sale at a gain. Basis is the same as in the hands of the donor (but not more than the value of the property at the time of the gift), plus any gift tax paid by the donor.
Sale at a loss. Basis is the lower of the donor's basis or the value of the gift at the time it was made.
Adjusted Gross Income
Adjusted gross income is more than a line on your tax return. It is a figure that's used to determine whether you are eligible for more than two dozen tax benefits--many of which are discussed throughout this book. These include:
- A $25,000 rental loss allowance.
- The portion of Social Security benefits included in income.
- An exclusion for interest on U.S. savings bonds used to pay higher education costs and an exclusion for employer-paid adoption expenses.
- Eligibility to make contributions to Coverdell education savings accounts, Roth IRAs, and deductible IRA contributions if an active plan participant.
- Eligibility to convert traditional IRAs to Roth IRAs.
- Above-the-line deductions for college tuition and student loan interest.
- A reduction in personal exemptions.
- An ability to claim itemized deductions--medical expenses, charitable contributions, casualty and theft losses, miscellaneous itemized expenses.
- A limit on itemized deductions.
- An ability to claim credits--child tax credit, dependent care credit, Hope and lifetime learning credits, earned income credit, credit for the elderly and disabled, adoption credit, health care credit, and credit for retirement savings contributions.
- Determining which estimated tax safe harbor rule to rely upon.
MODIFIED ADJUSTED GROSS INCOME (MAGI). In some cases, you can't simply look at the line on your tax return labeled "adjusted gross income" (line 35 of the 2002 Form 1040) to find the correct AGI limit--you must adjust your AGI by certain items. These items vary with the tax benefit involved. Typically, AGI is modified by ignoring certain exclusions (such as the exclusions for foreign earned income and savings bond interest used to pay higher education costs) to arrive at modified adjusted gross income (MAGI).
STRATEGIES FOR CONTROLLING AGI. Generally you aim to keep your AGI down so you are eligible to claim various tax write-offs or other benefits. In limited situations you may want to increase your AGI for certain purposes (such as to claim greater charitable contribution deductions). Here are some ways to achieve your objectives of decreasing (or increasing) AGI.
Using salary reduction options to decrease AGI. To the extent you reduce your income, your AGI is lower. You can so do without forgoing earnings by taking advantage of various salary reduction arrangements you may be offered. These include making contributions to 401( k) plans, 403( b) annuities, and SIMPLE plans (savings incentive match plans for employees) and contributing to flexible spending arrangements (FSAs) to pay for medical and dependent care expenses on a pre-tax basis. The amounts you contribute to salary reduction arrangements are not treated as current income--they are not included in your W-2 pay--so your AGI is lower even though you obtain a tax benefit from your earnings (retirement savings, selection of benefit options, etc.).
Investing for tax-free or tax-deferred income to decrease AGI. To the extent you can avoid reporting income this year you can keep your AGI down. Consider investing in tax-free bonds or tax-free bond funds if you are in a tax bracket above 27 percent. Also consider deferral-type investments--U.S. savings bonds and annuities--where income from earnings on the investments is not reported until a future year. Switch from dividend-paying stocks to growth stocks to eliminate current income while attaining appreciation that will be reported as capital gains later on.
Selling on an installment basis or making a tax-free exchange to decrease AGI. An installment sale spreads your income over the term you set so that your income won't spike in the year of the sale. Or defer the gain by making a tax-free exchange of investment or business property; any gain realized on the initial exchange is postponed until the property acquired in the exchange is later disposed of.
Using year-end strategies to decrease AGI. Defer income as explained earlier in this chapter to minimize your AGI for the current year. Important: Increasing your itemized deductions, such as deductions for medical expenses or charitable contributions, by accelerating discretionary payments won't cut your AGI (itemized deductions are taken into account after you figure your AGI).
Taking advantage of above-the-line deductions to decrease AGI. Make full use of the $3,000 capital loss write-off against ordinary income; make sure that you realize any investment losses before the end of the year to do so while enabling you to reposition your holdings. Learn about new write-offs (e.g., new deductions for an educator's out-of-pocket expenses or college tuition explained in Chapter 2).
Reporting a child's income on your return to increase AGI. If you have a child under age 14 whose only income for 2002 is less than $7,500, all of which is from interest, dividends, or capital gains distributions, you can elect to report the child's income on your return. Generally, this election is not advisable because it increases your AGI, thereby limiting your eligibility for many tax items. But in some cases, the election not only saves you the time and money of preparing a child's separate return, but also enables you to achieve some benefits. For example, you may be able to boost your investment interest deduction by adding your child's investment income to your own. Or you may be able to claim a larger charitable contribution deduction by increasing your AGI.