Tax Info Newsletter
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Tax Info Newsletter
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Dated: 02/27/2002 |
If you want to maximize your tax savings and minimize you tax exposure, you’ve got to start early.
The first thing you’ve got to understand about 2002 is that last year’s tax reform act changed a lot of the rules – in your favor. Once more, the tax rates are going down, and they’ll go down again in 2004.
For 2002 (and 2003), the tax rates are:
While these are only half percentage point reductions, in the highest bracket, their cumulative effect for those in the highest bracket is a 2 percentage point reduction from 2001. Remember, each half percent change in the rates represents dollars in your pockets rather than going to the IRS.
But the biggest benefits from new changes for 2002 come in the areas of education incentives and retirement planning. If you’re looking to save and save on taxes, there’s a lot to consider.
In addition, the definition of “qualified education expenses” that can be paid tax free from these accounts now includes both elementary and secondary school expenses. Starting this year, you can accumulate dollars on a potentially tax-free basis for pre-college educational expenses. Parents of children in private or religious schools who pay tuition in addition to property taxes for public education now can pay those tuition bills on a pre-tax rather than post-tax basis.
To qualify, the IRS wants you to meet income limitations. The phase-out range for married taxpayers filing a joint return is $190,000 to $220,000. But, you don’t need earned income to contribute to a Coverdell Education Account. So, if you make too much to qualify, make a gift of the dollars to your child and have the child make the contribution into the account!
In addition, you can now claim a Hope Credit or a Lifetime Learning Credit for a taxable year in which you exclude income from your Coverdell Education Account. The only restriction is that the credit must be for expenses that weren’t paid with Coverdell dollars.
What if you have left over dollars in the account? You can now roll over any unused Coverdell Education Account money, without penalty, to other family members, provided they are under age 30. The account has been renamed for the late Sen. Paul Coverdell, R-Ga.
And the new year’s gift from Congress: All distributions used for higher education purposes in 2002 are now tax- free rather than tax-deferred.
Let’s take the extreme situation. Assume you have a newborn baby. You put in the $110,000 into the account today. Even if the child doesn’t go to college, you’ve received as much as 30 years of tax-deferred growth.
Assume 29 years from now you remarry and have another child. You can transfer any unused dollars from the first child’s account into the account of the second child. That gives you another 30 years of tax-protected growth.
Now, 60 years later, the second child doesn’t go to college. Since you own the account, not the child, you can now take back all the dollars, including any income. You pay tax on the income, plus a 10% penalty.
Had you done nothing, you’d have to pay the tax annually as the income was earned. In exchange for a 10% penalty on the income, you’ve now gotten as much as 60 years in tax deferral with income compounding each year. It’s like a premature distribution from an IRA.
And, if you decided to take the money out after so many years, you’re way ahead – even with the penalty.
Several years ago, Jerrold J. Stern of Indiana University’s Graduate School of Business computed the break-even point for IRAs -- that is, the time at which the taxes and penalties would result in no cost to you if you withdraw the cash.
For someone in what was then the 28% bracket earning 6% a year in a non-deductible, you hit break-even after 18 years. If you’re earning 10% a year, breakeven drops to 11 years. A worst-case scenario of holding the money for 60 years means someone walks away with a relatively large amount of cash.
The break-even period will drop as tax rates fall under the new tax law.
It also repeals both the limit on the number of months (it used to be 60 months) during which interest paid on a qualifying loan is deductible and the restriction that voluntary payments of interest are not deductible. You can now get the deduction, no matter how long it takes you to pay off the loan.
If you’re age 50 or older, you can make an additional “catch-up” contribution of $500. That brings your potential 2002 contribution to a total of $3,500.
These catch-up contributions were designed as a matter of fairness to women, many of whom presumably were not working as they had and reared children. But workers of either sex can make these additional contributions.
Joint filers receive the 50% credit if their adjusted gross income is as much as $30,000. With AGI of as much as $50,000, they can still get a 10% credit. Singles can earn as much as $15,000 and still qualify for the 50% credit. They get the 10% credit with income as much as $25,000.
For more on retirement changes, see " Now you can build a bigger nest egg ."
This has focused on the major income tax changes for 2002. Some are substantive; many of them are mere numerical increases in contribution limits. In any case, unless you know the new rules, you can’t successfully play the tax game.
But knowing the rules alone isn’t enough. Unless you start saving for education and retirement now, the changes are meaningless. And the sooner you start your tax advantaged investment programs, the greater the benefit you’ll get from them.