How to Prepare for the Coming Tax Cuts

By now, you've probably heard about the $1.35 trillion, 10-year tax cut approved by Congress, but you may not know how each of its provisions will affect you as a taxpayer and as an investor. Here's a quick primer on what the changes are and what you should be doing to prepare for them.

In brief, the bill will first affect taxpayers through $40 billion in rebates that the government will mail by year-end: $300 for each individual, $500 for single parents and $600 for couples. Other highlights include gradually reducing income taxes across the board, while also gradually raising the annual limit on IRA and 401(k) contributions. The bill will also relieve married couples of the "marriage penalty" and double the $500 child tax credit by 2010. Last but not least, it will repeal the gift and estate tax in 2010.

Congress is expected to send the bill to President Bush to sign on or after June 5, when Congress returns from a weeklong Memorial Day vacation. Bush is expected to sign the bill, even though the tax cuts fall short of what he was originally looking for.

Rebates

The bill will first affect taxpayers -- and potentially investors -- through $40 billion in rebates that the Treasury Department will mail to 95 million taxpayers by Oct. 1.

A $300 check will be mailed to each individual, a $500 check to each single parent and a $600 check to couples filing jointly. The amount of these checks is based on a reduction in the tax rate from 15% to 10% that individuals pay on their first $6,000 in income, and that single parents pay for their first $10,000 in income.

While these rebates may not be a tremendous amount of money on an individual basis and account for only 0.4% of the nation's $10 trillion gross domestic product , some economists believe these checks could help the economy because they will be sent out at approximately the same time.

Lower Income Taxes

The centerpiece of the bill -- accounting for $875 billion of its cost -- is a reduction in income taxes across the board in almost every tax bracket.

Income tax rates will be reduced by three percentage points for all but the top bracket through four reductions that culminate in 2006, with the first -- a one-percentage-point reduction -- taking place on July 1 of this year. That means that by 2006, those in a 36% bracket will be in a 33% bracket, while the 31% bracket becomes 28% and the 28% bracket becomes 25%. Those in the 39.6% bracket will see their tax rate reduced even further, to 35%, while the 15% rate will remain the same.

According to Barry Freedman, a certified financial planner in Peabody, Mass, lower- and middle-income people will feel the effects of the tax cut the most because of their relatively lower earning power. A three-percentage-point reduction in taxes isn't as significant to someone earning $100,000 as it is to someone earning $30,000, he points out. "The lower-income people will spend that money and that's good for the economy," Freedman says.

But no matter what income bracket you're in, you should take advantage of the extra money you'll be getting by saving more, particularly for retirement, advises Larry Waller, a certified financial planner in Columbus, Ohio.

However, some economists and financial planners note that because these tax reductions won't be fully implemented until 2006, they won't have much of an effect for some time to come. There's also the possibility that some of the tax reductions may never go into effect if a future administration ends up repealing them.

"It's not going to have a great immediate benefit, and it's not certain that all of these provisions will be enacted 10 years from now when there is a different president in office," says Benjamin Tobias, a certified financial planner in Plantation, Fla.

A recent report issued by accounting firm KPMG on the tax bill also notes that because the benefits are deferred, "there is some question whether they will, in fact, take effect as scheduled -- especially if the economy in the future is not robust."

Bigger IRA, 401(k) Contributions

With respect to retirement savings, the new bill gradually increases the contributions that people can make to their IRAs and 401(k)s. Annual contribution limits to IRAs will rise from $2,000 to $5,000 by 2008, and contributions to 401(k)s and other defined contribution plans will rise from $10,500 to $15,000 by 2006. Financial planners hail the change as not only a significant improvement for retirement planning that helps contributions keep pace with inflation, but a good way to reduce the overall amount of income tax paid.

Freedman notes that for a married couple in a 30% tax bracket, the ability to contribute an additional $6,000 to an IRA reduces their taxes by $900. Being able to contribute an additional $9,000 as a couple to their 401(k) reduces their taxes by $2,700, he adds. "This is even more significant than a three-percentage-point reduction in taxes," Freedman says.

Breaks for Parents, Couples

The tax credit that parents get for each child will rise from $500 to $600 this year and gradually to $1,000 by 2010. Also, the so-called marriage penalty will be eliminated in 2005, so that the standard deduction a married couple filing jointly can claim will be equivalent to double the standard deduction that singles can claim. Currently, singles can deduct $4,550, but married couples can deduct only $7,600.

Further, the bill increases the annual limit on tax-free contributions to education savings accounts from $500 to $2,000 in 2002. Waller, the financial planner in Columbus, Ohio, says this is a sizable increase that parents should take advantage of.

Gayle Buff, a certified financial planner in Newton, Mass., says the change in the child tax credit is also notable because it is an actual reduction in taxes, rather than a tax deduction.

Elimination of the Estate Tax

The bill will also significantly increase estate tax exemptions over the next nine years and by 2010 eliminate the estate and gift tax altogether. Currently, heirs can inherit up to $675,000 in assets free of the estate and gift tax. The new tax bill will raise the amount of this exemption to $1 million in 2002 and to $3.5 million by 2009 (for more on how you should approach estate tax planning in light of the new bill, see this recent TSC story).

"This is huge relief, given that the estate tax exemption was only going to be $700,000 in 2002 and wasn't expected to reach $1 million until 2006. Now that exemption will be $2 million in 2006," says Herbert Karl Daroff, a certified financial planner in Boston.

From an estate-planning point of view, it might be good to hold off on going to the expense of signing an irrevocable trust, which people usually create to reduce their estate taxes, Freedman says. People also won't need to take out an insurance policy to help their heirs pay taxes, he adds.

Freedman also notes that this aspect of the tax-cut bill might eliminate the need for the wealthy to hire an estate-planning attorney altogether. "This [bill] could be the estate-planning attorney's nightmare," he says.

However, Weller notes that people concerned about estate taxes would be wise to retain estate-planning attorneys over the next 10 years as the estate tax exemption is gradually phased out, and should be prepared for the possibility that they might die unexpectedly during this period.