Tax Preparer update ... Complexity tamed
As we explain in this newsletter, complex computations for the highly-publicized tax cut rebate and unpublicized changes in the capital gains tax are not handled by the new IRS forms! Instead, more computations than ever are hidden in IRS instructions and publications. But Tax Preparer will handle them automatically, including a decade of changes, for the most accurate tax planning available.
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A decade of changes!
Because of the ubiquitous "tax cut" (the Economic Growth and Tax Relief Reconciliation Act of 2001), tax returns will change in a complex way every year for the next ten years. But the good news is that Tax Preparer will handle the changes for you. We値l review the decade of changes later, but first let痴 highlight two items that impact tax returns for 2001 and make Tax Preparer痴 automation more valuable than ever.
2001 "Tax Cut" complicates Form 1040
The use of rebate checks to give taxpayers a head start on the tax cut has added a complication to the calculations behind Form 1040. The checks are actually advance payments for a tax credit for 2001 that was created in lieu of a new 10% tax bracket. But the IRS cannot know the amount of credit you should receive until you file your tax return for 2001, so the rebate checks are based on your return for 2000! Therefore, the discrepancy between the check and the actual credit is reported on Form 1040 so that you can get all the credit for which you are eligible. The IRS has implemented this reconciliation by the mere addition of a single line on Form 1040. The computation of the amount to enter on that line, however, is found on a full-page worksheet in the IRS instructions for Form 1040. It痴 evidently all too complex for the IRS because the IRS has already sent over ｽ-million incorrect notices to taxpayers, overstating the amount of the rebate check they should expect to receive! But Tax Preparer will handle the reconciliation simply by adding an entry for the amount of the check received -- a critical entry missing from the IRS Form 1040 -- then compute the amount for the new line automatically. (Surprisingly, you do not have to pay the government back if the rebate check exceeds your allowed credit.)
1997 tax bill complicates Schedule D
The biggest surprise in the advance drafts from the IRS is the way they are changing Schedule D to reflect a provision legislated in 1997.
Background. Under that law, starting with tax year 2001 the capital gains tax rate for sales of property held for more than 5 years is 8% rather than 10% for those whose regular tax rate is 15%. This means that there are now three holding periods: one year or less, more than one year but no more than 5 years, and 5 years or more. The IRS would therefore logically add another section to page 1 of Schedule D to reflect the new 5-year holding period.
The IRS way: the illusion of simplicity. The IRS has not changed page 1 of Schedule D, so sales of property held 5 years or more are commingled with those held less than 5 years! As a result, there is no line on Schedule D that holds the total gain for property eligible for the new lower rate, and therefore no line from which to calculate the reduced tax! Instead, the preparer must keep track of those properties separately from the IRS form in order to perform the proper calculation of tax on page 2 of Schedule D. Even if the IRS had redesigned page 1 logically, the addition of an 8% rate would still lengthen the computation of tax on page 2 of the form. But the IRS has instead shortened the computation on the form by ignoring several cases that were formerly handled by the form. Capital gains subject to a 28% tax rate (shown in column (g) on side 1 of Schedule D) and those subject to a 25% tax rate (certain real estate depreciation, called "unrecaptured section 1250 gain") are no longer handled by Schedule D. Instead, the IRS now refers you to special instructions, making the new page 2 of Schedule D useless if you have sales for either of these cases.
The HowardSoft way: the reality of automation. By contrast, Tax Preparer will handle the new computation with on-screen forms that avert the extra manual effort that will be required under the new IRS design. Our printouts will conform with the IRS form, of course, but our calculations and data entry format are designed for minimal effort on your part, not illusory simplicity that must be backed by complex manual calculations.
The truth about the "Tax Cut"
The ubiquitous "tax cut" (the Economic Growth and Tax Relief Reconciliation Act of 2001) is theoretically the most massive tax cut since 1981. Yet the tax cuts are phased in so slowly that little of the $1.35 trillion in cuts will be felt in the initial years of the 10-year phase-in. And there is good reason to believe that future bills will modify the new law before many of the changes come into play. But even if all provisions remain, the new rules are set by the bill to revert back to the pre-2001 rules in 2011! So here痴 a brief overview to put the changes in perspective.
Only the first four changes affect returns for tax year 2001:
Splitting of the lowest tax bracket. This change lowers the 15% tax rate to a 10% tax rate for the first few thousand dollars of income. For tax year 2001, the 10% rate applies to the first $6,000 of income for singles, $12,000 for couples filing jointly, and $10,000 for heads of households. Above these levels the old 15% rate applies to the end of its usual range. (Note that, unlike all other brackets, the end of the 10% bracket is not adjusted with inflation until 2009. Instead, the end of the bracket is unchanged through 2007 then jumps to $7,000 for singles and $14,000 for couples in 2008.) In spite of the law, you won稚 see the new 10% bracket in the tax tables and tax rate schedules for 2001! Instead, it is being handled as a credit, as detailed earlier in our description of the new Form 1040.
Reduction in the top tax brackets. The top four tax brackets are reduced gradually from now through 2006. The first reduction is technically a 1% reduction in all four brackets starting July 1, 2001, and employers are now using new withholding tables that reflect this. Nevertheless, you won稚 see a new set a tax tables and tax rate schedules reflecting the 1% reduction in the second half of 2001, but rather a ｽ% reduction in each bracket for the entire year! This approach averts a computation nightmare, not to mention a W-2 reporting nightmare for employers, and has little effect on most taxpayers. (All four brackets drop another 1% in 2004, then 1% in 2006 for the first three brackets and 2.6% for the top bracket. But all brackets return to their pre-2001 rates in 2011!)
Increase in child tax credit. The child tax credit is raised to $600 per child for tax year 2001, up from $500 last year. (It is further raised to $700 for 2005, $800 for 2009, and $1,000 for 2010, only to drop back to $500 in 2011.)
Temporary increase in AMT exemption. The exemption from the alternative minimum tax is raised by $4,000 for couples ($2,000 for singles) for tax year 2001, but it reverts back to the old levels in 2005!
The remaining changes affect only returns for future years:
Repeal of phase-out of itemized deductions and personal exemptions. The phase-out of itemized deductions and personal exemptions with high income is reduced by one-third in 2006, reduced by two-thirds in 2008, and eliminated altogether in 2010, only to come back in full force in 2011.
Relief from the "marriage penalty." Several new provisions address the penalty on working couples who both earn a substantial part of the family痴 income:
Increase in standard deduction. When in full effect (in 2009) the standard deduction for couples will be double that for singles. The ratio rises to 1.74, 1.84, 1.87, 1.9 and 2.0 in tax years 2005, 2006, 2007, 2008, and 2009, only to fall back to its current 1.67 in 2011.
Increase in end of 15% tax bracket. When in full effect (in 2008) the end of the 15% tax bracket for couples will be double that for singles. The ratio rises to 1.8, 1.87, 1.93, and 2.0 in tax years 2005, 2006, 2007, and 2008, only to fall back to its current 1.67 in 2011.
Increase in income levels over which EIC phases out. The beginning of the phase-out range for the earned income credit is raised for couples by $1,000 for 2002-2004, $2,000 for 2005-2007, and $3,000 in 2008-2010.
Increase in income levels at which Education IRA phases out. Currently, the amount a benefactor can contribute to a child痴 account is reduced when the benefactor痴 AGI exceeds $150,000 for couples ($95,000 for singles). Starting 2002, the income level for couples is raised to $190,000, double the level for singles.
Increase in income levels at which student loan deduction phases out. Currently, the income levels for the phaseout range are about 1.7 times the levels for singles. Starting 2002, however, the levels are exactly double those for singles, and substantially raised for both couples and singles.
Simplification of the EIC rules. Among other simplifications, starting in 2002 the AGI base used for the calculation is changed from the complex modified AGI to the regular AGI (line 33 of Form 1040) and the effect of the alternative minimum tax is eliminated.
Increase in maximum Traditional IRA deduction. The current maximum deduction of $2,000 per taxpayer is raised to $3,000 in 2002, $4,000 in 2005, and $5,000 in 2008, then indexed for inflation thereafter.
Increase in child/dependent care credit. Starting with tax year 2002, the limit on expenses eligible for a partial credit are raised from $2,400 per child ($4,800 maximum) to $3,000 per child ($6,000 maximum). The credit percentage is also raised for low-income taxpayers by changing the maximum rate from 30% of eligible expenses to 35%, and starting the reduction to 20% at $15,000 of income instead of $10,000.
Increase in maximum Education IRA deduction. The current maximum contribution of $500 jumps to $2,000 in tax year 2002. Moreover, the full $2,000 can be contributed by couples whose AGI doesn稚 exceed $190,000, double the level for singles.
Introduction of a deduction for higher education expenses. This new deduction does not take effect until 2002 but will surely add a great deal of confusion to taxpayers because it overlaps the intent of the current Hope and Lifetime Learning Credits. It cannot be used for the same student in the same year as the credits, so taxpayers will have to decide each year whether the new deduction or the old credit provides the greater tax benefit, a decision that will vary with the tax bracket and AGI of the taxpayers. For couples with AGI no greater than $130,000 ($65,000 for singles), the new deduction provides up to $3,000 deduction in 2002 and 2003 and $4,000 in 2004 and 2005. For 2004 and 2005, a $2,000 deduction is allowed for those who exceed the AGI limit but whose AGI is less than $160,000 ($80,000 for singles). However, the new deduction expires on Dec. 31, 2005.
Liberalization of the student loan deduction. The current rule that interest beyond the first 5 years of required payments is not eligible for the deduction is repealed after 2001. At the same time the phase-out levels are raised for couples from $60,000-$75,000 to $100,000-$130,000, and for singles from $40,000-$55,000 to $50,000-$65,000.