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Tax Newsletter
July 2001

Current Year Rate Changes; Relief From Marriage Penalty

As described in last month’s newsletter, many of the changes reflected in the recently-enacted Economic Growth and Tax Relief Reconciliation Act of 2001 (“the Tax Act”) are phased in over as many as ten years. Changes in individual income tax rates are subject to such a phase-in, with relatively minor changes in the short term. Marriage penalty relief, a hot topic in recent years, will not commence until 2005.

Short-term rate changes. Currently, the graduated income tax rate structure includes brackets at 15%, 28%, 31%, 35% and 39.6%. Over the next five years, these brackets will be reduced by 3% in most cases, but 4.6% for the highest bracket (39.6% to 35%). For 2001, the Tax Act introduces a new 10% bracket.

The check is in the mail. For 2001, the 10% rate will apply to the first $6,000 of taxable income for a single taxpayer, $12,000 for joint filers. The benefit of the 10% rate in 2001 will be computed via a tax credit.

Taxpayers have been hearing about checks that will be sent to them during 2001 as a result of the Tax Act. In essence, these checks are a prepayment of the benefit taxpayers are expected to receive as a result of the creation of the 10% tax bracket. The amount of the checks are based on taxpayers’ 2000 tax returns. Taxpayers must take this refund into account in computing their 2001 tax liability.

For most taxpayers, the amount of the refund check will equal the amount of benefit to which they are entitled through creation of the 10% bracket. In some cases, however, the refund check will be more or less than the amount to which the taxpayer is entitled. Since the refund checks are based on a taxpayer’s 2000 individual income tax return, certain changes in status or filing between 2000 and 2001 could create a situation in which the amount of the refund check differs from the rate change benefit. In such cases, a taxpayer may have to make an adjustment on his or her 2001 return.

Elimination of the marriage penalty. For many years, taxpayers have sought relief from the “marriage penalty” associated with the existing income tax structure. With the enactment of the Tax Act, the marriage penalty for many joint filers has finally been eliminated.

Because of graduated income tax rates, a married couple’s joint tax liability would often exceed their combined liability if each had filed separate returns. Generally, a couple whose incomes were split 70-30 (or more evenly) suffered a marriage penalty. The following provisions contributed to the disparity:

  • Tax brackets were divided into 15%, 28%, 31%, 36.5% and 39% brackets. Two single taxpayers would enjoy larger 15% and 28% tax brackets than joint filers. For example, for 2000, the first $26,250 of a singe person’s taxable income was taxed at 15%. For two single taxpayers, this translated to $52,500. For joint filers, the 15% bracket terminated at $43,850.
  • The standard deduction for single filers was $4,400. This was more than 60% of the $7,350 standard deduction allowed for joint filers

The Tax Act seeks to eliminate this penalty by the following:

  • Increasing the size of the 15% bracket for joint filers, beginning in 2005.
  • Increasing the standard deduction (however, this comes into effect in 2005. Beginning in 2005, the standard deduction for a joint couple will increase until 2009, when it will equal twice the standard deduction for a single individual. The standard deduction for joint filers will be computed as a percentage of the inflation-adjusted standard deduction for single individuals.

Increased exposure to AMT. Although many joint filers will benefit from the elimination of the marriage penalty, the number of joint filers subject to alternative minimum tax (AMT) is likely to increase. While the Tax Act reduced the tax rates for regular tax purposes, there was no corresponding adjustment to alternative minimum tax rates. Thus, a couple’s regular tax liability will decrease due to the reduction in regular tax rates; however, this may drive them into AMT.

Similarly, an increased standard deduction may be more favorable for joint filers for regular tax purposes. However, because the standard deduction is a tax preference for AMT purposes (i.e., taxpayers are not permitted to claim the standard deduction in computing alternative minimum tax), the larger standard deduction may cause joint filers to be subject to AMT.

Planning for rate changes. With a reduction in tax rates (albeit modest), taxpayers may derive benefit from income deferral strategies. Similarly, acceleration of deductions may be beneficial. However, there are two important caveats to this latter strategy. First, increased deductions may very well expose taxpayers to AMT. In addition, the Tax Act provides for the ultimate elimination of the provision that currently limits an individual’s itemized deductions. Thus, taxpayers may derive a greater benefit in future years in which they are able to claim the full benefit of their deductions.

Please feel free to contact us should you have any questions regarding the foregoing.

The information contained in this newsletter is general in nature and does not constitute tax advice or opinion. Applicability to specific situations should be determined through consultation with your tax advisor.

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