New year brings some federal tax changes

January 26, 2003|By Sue Stevens | Sue Stevens,MORNINGSTAR.COM

With spring on the horizon, it seems like everyone's talking about income taxes. It sure looks like there will be new legislation this year. But before we go too far in speculating about what may be next, let's review the tax changes for 2003.

Income taxes

Although tax rates aren't scheduled to change until next year, the brackets have expanded. You can earn a little more before you are pushed into the next marginal tax bracket.

Marginal brackets for 2004 and beyond are estimated by using a 3 percent increase per year over 2002 figures excluding the 10 percent bracket.

For planning purposes, you'll want to understand not only how your "marginal" tax bracket is changing, but also how this affects your "effective" tax rate.

Your "marginal" tax bracket is the top tier of tax that you pay on taxable income.

The tax tables are structured so that everyone pays the same rate on the first few thousand dollars.

So, for example, if you earn $30,000 in 2003, the first $6,000 would be taxed at 10 percent, the next $22,400 ($28,400 minus $6,000) would be taxed at 15 percent. Only $1,600 would be taxed at the "marginal" bracket of 27 percent.

Your "effective" tax rate is found by dividing your "total tax" by your "taxable income."

Most people will see their marginal tax bracket go down by a couple of percentage points over the next 10 years.

That's not going to make a substantial difference, but every little bit helps.

Knowing how the tax rates change can be an important planning tool for those thinking about important life changes - perhaps having only one spouse working or phasing into retirement.

Estate taxes

Estate tax rates will come down. In fact, in 2010 they're scheduled to go away completely. But before you make any changes to your estate plan, you should know that the "sunset" provision of the new tax act allows for all the current estate tax to come back in 2011. Quite a dilemma from a planning perspective.

Most people think that some type of estate tax still will exist in the future. So you want to structure your estate documents for maximum flexibility over time.

Many of you are familiar with the concept of passing a certain amount of money tax-free to your heirs. The amount that you're allowed to pass is called an "exemption equivalent."

Right now that amount is $1 million per person (2002-2003). That will increase over time to $3.5 million. Only amounts over these thresholds will be taxed.

For the average person, much of the hoopla over estate taxes is much ado about nothing. If your estate will be less than $1 million, your heirs won't have to pay any estate tax - not now and not in the future.

But you might be surprised at just how many people will have an estate worth more than $1 million. There is talk of making the elimination of the estate tax permanent. Don't believe it until you see it.

The need for careful recordkeeping of cost basis will be one of the most important gifts you can leave for your heirs.

Gift tax

You can give $11,000 a year each to as many people as you'd like without owing the gift tax.

If you're married, you can "gift-split" (that means you and your spouse split the amount given between you) up to $22,000 a year to whomever you'd like with no gift tax problems.

If you give more than those thresholds, you will have to file a gift tax return and pay tax at the same rates as estate tax.

(Technically, you also need to file a gift tax return if you gift-split up to $22,000, but no tax would be due.)

We all are allowed a unified credit for estate and gift tax. The credit offsets gift or estate taxes so that you can pass the exemption equivalent amount (see above) to your heirs.

In 2003 the exemption equivalent amount is $1 million for both the gift and estate tax for your lifetime.

However, while the estate tax exemption equivalent continues to increase to $3.5 million in 2009, the gift tax exemption equivalent remains constant at $1 million (without any increases for inflation).

Retirement plan changes

The new year brings more increases for retirement plan contributions. People older than age 50 will be able to make "catch-up" contributions.

For IRAs, the catch-up amount for 2003 to 2005 is $500, and for 2006 and on it is $1,000. For example, in 2003 you can contribute a maximum of $3,500 to your IRA if you are age 50 or older.

Salary-reduction plans, such as a 401(k) or 403(b) plan, will allow even more generous catch-up contributions. In 2003, you can contribute $12,000 to these plans and another $2,000 if you are older than age 50.

With a little planning, you can maximize the way you put your money to work. Think about these possibilities:

Defer income to future years as tax rates go down. Accelerate deductions as much as possible. They are more valuable when tax rates are higher.

Compare the capital-gains tax rates (not scheduled to change) to ordinary income tax rates. As the spread between them narrows, you may find there is less of an advantage to holding investments over a longer period so that they will be taxed at capital-gains rates.

Although tax considerations shouldn't drive your investment decisions, they can be an important factor in your returns.

Make sure you've calculated the basis on your investments and re-evaluate when you plan to sell your investments.

If you feel you're behind on saving for retirement, do some planning to include higher contributions, especially if you're older than 50.

Think about the timing of gifts. For people who expect to exceed the $1 million gift tax exemption equivalent amount, there will be an incentive to slow or stop gifts so that property passes at death when the exemption equivalent increases.

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