The Tax Act of 2001: New Horizons for Investors

Air Line Pilot, September 2001, p. 28
By Milo M. Zonka, AAMS

In June 7, President George W. Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001. I’m sure all of you readers are sifting through your own copy of the new tax code while planning around-the-world flights with your E6-B, so this summary isn’t necessary. But in the event you haven’t had time to take a look at the Act, you’ll find the highlights and how they may affect you on the following pages.

This tax-cut package has provisions that affect your entire life cycle—annual income tax, saving for retirement and college, and estate tax provisions. For both political and fiscal reasons, however, most of the provisions are phased in over time, which can be critical for planning purposes. Finally, at some point, all of these provisions "drop dead," and we revert back to the tax rates and programs as we know them today. More on that later.

Why is this important?

Because these tax changes are so broad in scope and generally deep in their impact, you have the opportunity to benefit greatly. Federal taxes are pervasive and extremely punitive to those who earn the most. According to the Tax Foundation, a nonprofit, nonpartisan watchdog group, our "tax freedom day" this year was May 3. In other words, the average U.S. taxpayer worked 123 days this year to pay all of the various federal, state, and local taxes. Of that total, 79 days were spent working to pay for federal income and payroll taxes. Taxes cannot be ignored, but they can be avoided. The best way to avoid taxes is to manage them as part of a comprehensive financial plan that addresses your life goals.

Income taxes

Income tax reductions are the heart of the new tax package. While the cuts are not as deep as President Bush had desired, substantial changes are coming.

Reductions in marginal income tax rates account for $874 billion of the overall $1.35 trillion 11-year package. The immediate effect of the Act is the creation of a new 10 percent tax bracket for the first $6,000 of earnings for single filers and the first $12,000 for those filing jointly effective beginning in 2001. Tax withholding tables will not change for 2001, so those filers who paid taxes in 2000 have received or will receive a rebate of as much as $600 sometime this summer or fall.

Tax bracket adjustments are occurring for 2001, with the introduction of the 10 percent bracket and an average 0.5 percent reduction in rates for other brackets for the year. Additional incremental cuts occur in 2002, 2004, and 2006 (see Figure 1, which shows the rates for the highest bracket). Other major items include the following:

In spite of the rate reductions, the most powerful effect of the Act is in the areas of education savings, retirement savings, and estate tax (a.k.a. "death tax") reform. The decrease in the highest bracket results in reducing the 39.6 percent bracket to 35 percent in 2006.

Let’s take a look at some tax management tools that benefit investors and might help to leverage the tax-avoidance opportunities available.

Education savings

The No. 2 goal of the American family is to save for a child’s or grandchild’s college education. College degrees are becoming more important in the job market, and according to the College Board, the holder of a bachelor’s degree can expect additional lifetime earnings of more than $1 million over those who do not have a degree.

The challenge of financing a college education has increased over time, due mostly to the rise of educational expenses in excess of inflation. With each passing year, our dollars have less buying power at colleges and universities. According to the College Board, the 10-year inflation rate average for college costs has been approximately 5 percent, while the Consumer Price Index has risen on average less than 3 percent. For a child born today, a 4-year education at a private institution may cost more than $200,000, assuming the 5 percent rate continues (see Figure 2).

Saving for college has always been a choice of the lesser of the evils. Saving in your retirement accounts for college expenses offers tax deferral and no penalty on withdrawals for qualified education expenses, but that eats into your ability to save for your own retirement. Taxable investments are an annual burden, thanks to income and capital gains taxes. Uniform Gifts/Transfers to Minors Act accounts (UGMA/UTMA) have some tax benefits, but ownership and control of the accounts pass to the child when they reach your state’s age of majority. Those hard-earned dollars you saved to send your child to college may instead be used to backpack around Europe with a friend who has three nose rings.

So the issues with college savings are taxes, control, and ability to save and invest to earn the substantial amounts that will be required. Congress has answered the call and "turbo-charged" two preexisting options: the Education IRA and the Section 529 Qualified Tuition Plan.

Education IRAs

Education IRAs have been largely ignored because of the limitations on contributions ($500 annually) and eligibility (phase-out beginning at $150,000 for joint filers). Beginning in 2002, parents will be allowed to contribute $2,000 annually to Education IRAs with the phase-out beginning at $190,000 for joint filers. Qualified withdrawals are free from federal income tax and may be used for both college and elementary and secondary school expenses, which is new. Want to send Junior to private school? This is a great way to do it.

Section 529 qualified tuition plans

As for 529 plans, the changes are dramatic. These are professionally managed investment vehicles that have offered tax-deferral and special tax advantages for qualified college expenses (tuition, fees, and room and board). These plans are relatively new but are catching on fast, and the push will become only stronger with the change to federal income-tax–free withdrawals for qualified expenses effective for state-sponsored plans beginning in 2002 and for privately sponsored plans beginning in 2004.

If tax-deferral and tax-free gains aren’t enough, the other major advantages of 529 plans are contribution limits (the highest limit is more than $246,000, depending on the plan you choose), no income limitations, and a unique twist that allows you to contribute $50,000 per donor to a beneficiary’s account without incurring any gift taxes (with some stipulations if you die within 5 years of the gift). Donations may be made by anyone to anyone—a beneficiary can receive contributions from a parent, grandparent, neighbor, etc.—and the ownership is maintained by the account owner/donor (presumably a parent).

If the beneficiary doesn’t attend college, the owner can roll the account over to another related beneficiary with-out penalty, or remove the funds from the account (and be subject to income taxes and a 10 percent penalty). No Harleys being bought with your college money here.

One final note on saving for college: make no mistake, Junior can always get scholarships or financial aid, but nobody will come to your rescue when age 60 hits. Pay yourself first, then do what you can for your kids. They’ll appreciate it if you’re not forced to move into their garage after you’re retired.

Retirement savings

Airline pilots are fortunate that, through the strength
of a steadfast union, substantial attention and resources are dedicated to their retirement plans.

These retirement plans may take the form of an "A Plan" (defined-benefit pension plan), a "B Plan" (individual account plan) for employer contributions, and/or a 401(k) or similar plan for employee contributions.

Know these plans and use them to their full advantage. That’s the extent of my lecture.

The benefits available to ALPA pilots are, by and large, the best available to any class of employees in the United States today, and recent contract negotiations are bent on making the best even better.

The new tax act has made substantial improvements to retirement planning vehicles, both corporate-sponsored and individual plans. In this article we’ll review changes made by the Act that you, the employee, can control and take advantage of.

401(k) plans

Some 401(k) plans have unique limits, and matching benefits and employer contributions vary, but these plans can constitute a substantial portion of your retirement assets. Most importantly, the new tax act has increased the dollar limits on what you may defer and invest in the plan. The $10,500 cap on employee 401(k) pre-tax contributions will rise to $11,000 in 2002 and, beginning in 2003, will increase in $1,000 annual increments until the cap reaches $15,000 in 2006, with indexing thereafter (see Figure 3).

A new feature that 401(k) plans may offer is the "catch-up contribution" for employees 50 or older. These employees will be able to defer additional income up to $1,000 beginning in 2002, and this will increase by $1,000 each year until the maximum amount reaches $5,000 in 2006. The catch-up contributions will be in addition to any other contributions, so that for those age 50 or older, a $20,000 contribution to your 401(k) account will be possible beginning in 2006.

Another new feature will debut in 2006—the Roth 401(k). After-tax contributions will be allowed, if your plan permits, and "qualified distributions" will be available in retirement on a tax-free basis, similar to the current Roth IRA, except the Roth 401(k) has no income limitation on eligibility. Roth contributions, combined with any pre-tax contributions made during the year, may not exceed the applicable limit on elective deferrals (e.g., $15,000 in 2006).

Individual retirement accounts

The Act also increases the amount that may be contributed to an IRA, for both the traditional and the Roth IRA. The maximum contribution will rise to $3,000 in 2002 through 2004; $4,000 in 2005 through 2007; and $5,000 in 2008, after which it will be indexed (see Figure 4). Income limitations on deductible traditional IRA contributions and Roth eligibility still apply.

Catch-up contributions for those 50 and over will also
be permitted to IRAs, beginning in 2002 with a $500 maximum. This will rise to $1,000 in additional contributions in 2006.

With these changes, the IRA becomes a more powerful savings and retirement tool. With a hypothetical 8 percent return over 20 years, a $5,000 annual contribution to a Roth IRA can grow to $247,115, versus $98,846 for a $2,000 contribution, all of which would be free from federal income tax. Additional catch-up contributions could in-crease that amount even more. In my experience, investors never regret saving too much if they can do it without significantly imposing on their lifestyle. To the contrary, saving too little and realizing it too late could be catastrophic to your effort to meet your personal goals and dreams for retirement.

The death tax

Assume for a moment that you do save too much—you’re living well in retirement, the boat requires less maintenance than you budgeted, and you really don’t want to go on those around-the-world trips every year. You now are concerned about how to transfer your accumulated wealth to those you love and the institutions you value.

Less than 2 percent of estates pay estate taxes, but the revenue is substantial. Under the Act, the tax is nibbled away by lowering marginal rates and increasing exemptions until 2010, when the estate tax disappears entirely (see Figure 5). Of course, some conditions still apply. In exchange for eliminating the estate tax in its present form, we lose the benefit of cost basis step-up at death. For example, if you bought 1,000 shares of the 21st century equivalent of Microsoft for $10,000 that at your death was valued at $5,000,000, in 2010 your estate won’t pay taxes to transfer the shares to your heirs, but they maintain your original cost basis in the stock ($10,000).

When your heirs sell the stock, they’ll be subject to capital gains on the sales price minus your cost, or $4.99 million. The tax code that will be in effect in 2010 grants a $1.3 million exemption from taxes for all heirs combined (the "general basis increase"). A spouse will receive an additional $3 million exemption (the "spousal property basis increase"). In the example above, if a decedent passes his or her entire estate to nonspouse beneficiaries, capital gains taxes would have to be paid on all realized gains of more than $1.31 million (the $1.3 million general basis increase plus the $10,000 original cost basis). If the entire estate goes to a spouse, taxes would be imposed only on gains greater than $4.31 million. Transfers to qualified charities will remain exempt from estate taxes.

This tax may not affect as many estates as the present tax, but it does change some of the planning criteria you should consider as you create an estate plan. With the changes, you should have a flexible estate plan that ad-dresses the tax as it is today, the tax that evolves and matures in 2010, and any future taxes that must be assumed.

A big caveat

Unfortunately, due to the language in the Act, all of the provisions of the Act have a "sunset provision," meaning that as of Jan. 1, 2011, all of the tax changes discussed here expire, and we revert back to current tax code. What does this mean to you? The most dramatic example is the estate tax; if you die in 2009, your estate would be subject to a reduced form of the tax we know today—the highest marginal rate would be 45 percent of estate value in excess of $3.5 million (the "applicable exclusion amount") in assets. In 2010, the estate tax is repealed, and your estate will be subject to the cost basis provisions only. In 2011, we’re back to the tax we have today, with a maximum marginal rate of 55 percent!

As was said earlier, and as you can see from the individual charts, this tax reform is a very back-end–loaded package. Depending on the strength of the economy and the tax collections at the time, a future Congress and President may be forced to eliminate some of these provisions when they come up for review in 2010.

According to a report from the congressional Joint Committee on Taxation, in 2010 the cost of the total package is estimated at $187 billion. Of that amount, $118 billion comes from the marginal rate reductions discussed in the first section. Marriage penalty tax elimination and the expansion of the child tax credit account for approximately $34 billion. The balance is spread among all the other provisions of the Act. While we cannot now predict what provisions, if any, will be vulnerable in the future, many experts believe that those tax reductions that are most pervasive and middle-class oriented (marginal rate reductions, as well as education and retirement savings stand out here) will have a stronger chance of survival.

Key to all of this is, when establishing your goals, be sure to create a financial plan that is flexible enough to adapt to future scenarios. Tax law will continue to change, and you should continue to update and amend your plans to achieve the most beneficial results. And be aware that the information in this article was obtained from sources believed to be reliable, but its accuracy is not guaranteed. Consult your attorney or tax advisor for complete up-to-date information concerning federal and state tax laws before taking any action.

Expect some weather reroutes, perhaps a few ATC delays and a cancellation or two, but load enough fuel to get you to your destination so that you have a good chance of arriving safely and in style.

Milo M. Zonka, AAMS, is a financial consultant with the A.G. Edwards & Sons Coral Gables (Fla.) branch and holds the Accredited Asset Management Specialist designation from the College of Financial Planning. He is a licensed commercial pilot and aircraft dispatcher who previously worked in the airline industry as a dispatcher and flight operations manager. He specializes in family financial planning, including developing long-term strategies for funding education and retirement expenses, and may be reached for questions or comments at 1-800- 945-2310 or by e-mail at