TAX NEWS & TIPS

Mid Year 2003

2003 TAX LAW ISSUE

For years married couples have paid more tax than if they were two single filers. Congress modified two key rules that penalize couples.

Standard Deduction. Couples now get a standard deduction twice as large as single filers - $9,500 vs. $4,750. Before the change couples got $7,950. This change alone saves tax on $1,550 for those who cannot itemize their deductions.

The gory details. The change applies to 2003 and 2004. In ’05 through ’08 couples won’t get 200% of singles, but 174%, 184%, 187%, then 193%. Then back to 200% for 3 years. The law has several rules like this. Zany but true. Trust me. The law will be changed.

Tax Brackets. The 10% tax rate applied to the first $6,000 of taxable income for single filers and $12,000 for couples. The figures are changed to $7,000 and $14,000. Again it’s a temporary change for 2003 and 2004 only. Then the old numbers return.

The big change is in the 15% tax bracket. Before the new law this bracket ended at $28,400 of taxable income for single filers and $47,450 for a couple. Now couples get twice the single’s figure, $56,800. This change alone saves $1,122 for a couple with sufficient income to fully use this bracket.

Marriage Penalty Alive & Well. There are still several ways in which couples face extra tax. They do not use figures twice as large as singles in calculating capital losses, taxable Social Security, allowed losses from rentals, and several other items. The first steps have been taken. Let’s hope we see more changes here.

The new law reduces tax rates for everyone. If you actually pay any income tax your bill will be smaller. The changes are retroactive to cover all of 2003. The brackets:

• 10% - is a little wider
• 15% - wider for couples
• 27% - reduced to 25%
• 30% - reduced to 28%
• 35% - reduced to 33%
• 38.6% reduced to 35%

Many people already got a check from IRS. Here’s what the law told IRS to do:

A dependent child under age 17 can get you a Child Tax Credit. The $600 credit was increased to $1,000 for 2003. IRS was told to pay the extra $400 now. They looked at your 2002 tax return. You got paid if your return made it appear the credit would apply in 2003.

Problem – the credit can be lost.

High income can hurt. A couple begins to lose the credit when their income passes $110K ($75K for single filers). You lose $50 of the credit for each $1,000 of income above this amount.

Low incomes need a two-step calculation. Step One, if the credit is larger than your income tax, the tax is wiped out and excess credit is lost. Step Two can refund the lost credit if your "earned income" (from a job usually) is above $10,150. Complex.

Congress thinks the advance rebate of the extra $400 per child will stimulate the economy.

Possible Problems. These rebate checks have caused many questions. Here are the most common issues.

Got the right amount. If you got $400 for each child under 17, you must keep a clear record of this. When we file your return we’ll claim a credit of $1,000, but since you already received $400, only the additional $600 will be claimed.

Got nothing or too little. Here are a few of the cases. If the child will be age 17 in 2003, you got the credit in 2002 but will not be able to claim it in 2003. If your return was on extension, IRS had no return to look at – your full credit will be claimed when we file your 2003 return. If your income was too high, the credit was lost, but we may be able to claim the full $1,000 if your 2003 income is smaller. With lower incomes, that two-step test I spoke of may show you are entitled to some odd amount less than $400.

Got it – but won’t qualify. IRS based their calculations on your 2002 return. Some separated parents claim the child in alternating years. If the child was on mom’s return in 2002 mom got a check. When dad claims the child for 2003 he gets a full $1,000 credit. It appears mom can keep the $400 she received! IRS might change its stance on this one.

Another scenario – your 2002 income allowed the credit, but your 2003 will be so large the credit is lost. You can keep the $400!

PLEASE – keep good records. As you can see, we’ll need to work all this out when we file your 2003 return. I’ll need to know exactly what you received. Best is to find the letter IRS sent you, but at least record the total while you remember.

Capital Gains

The capital gains tax is sharply reduced for gains after May 5, 2003. A capital gain is your "profit" from selling stocks, bonds, real estate, or other passive investments. To fully understand this area you need to keep three ideas in mind:

1. Net Gain. First, capital gains and losses for the year are calculated and netted. If the net is a loss, you may deduct at most $3,000 and carry the balance to future years. If the net is a gain, it will be taxed.

2. Long-Term. An asset you hold for more than a year is "long-term" when you sell. If the net in Step 1 is a gain, but the gain is from short-term assets, it is taxed like any other income. Only the net gain which is long-term gets the special capital gain rates.

3. Maximum Rate. Any long-term capital gain acts as if it "floats" on your other taxable income. The diagram shows a long-term gain "floating" so that part falls in the 15% bracket and a larger part in the 25% bracket. Capital gain rates are described with two figures – for example 10%/20%. They are the maximum rates at which the gain can be taxed. Compare them with tax brackets and pay at the smaller rate. For sales before May 6, 2003 the capital gain rate is 10%/20%. That is, the part of gain below the 25% bracket is taxed no higher than 10%. The part in the 25% bracket is taxed at 20% - the maximum allowed rate.

New Rates – 5%/15%. For sales on May 6 or later, the lower part of the gain has a maximum rate of 5%. The part in the 25% bracket is held to a 15% rate.

NOTE: For real estate – if some of the gain is from depreciation, this part has a maximum rate of 25%. There are also higher rates for gains on collectibles and bullion.

These rates will apply through the year 2007. For 2008 the rates will be 0%/15%. Thus for year 2008 alone, there is no tax at all on gains falling below the 25% bracket. After 2008 rates return to the 10%/20% levels. The law may change before then.

Another huge change. Dividends represent a share of profits from a company in which you own stock. The new law will tax corporate dividends as if they were long-term capital gains. The same 5%/15% capital gain rates apply. Using the "floating income" concept the tax on $1,000 of dividend income will be only $50 instead of up to $150 for those in lower brackets. For folks in 25% or higher brackets the tax will be $150 instead of as much as $350.

The new rates apply only to certain dividends. For instance, your credit union pays a "dividend" on your deposits. This is really interest income. Some of the "dividend" paid by a mutual fund is really interest on cash accounts or short-term capital gain.

Your dividend income is not a capital gain. The tax is calculated at capital gain rates. Thus, you will not be able to use capital losses to offset dividend income.

These new rules for dividend capital gain income will lead to confusion at tax time. We expect to see very complicated statements from banks and brokers. Capital gains must be separated for sales before May 6 and those after May 5. Dividends must be broken down to show dividends qualifying for the tax break, and those which are ordinary income.

The law changes how businesses deduct the cost of new equipment. Normally we "write-off" supplies. Equipment is "depreciated" over a period of years.

Expensing Provisions. Smaller businesses are allowed to write off certain items that normally would be depreciated. This applies to nearly anything except real estate and items used in rental properties. The old law allowed up to $25,000 of such equipment to be written off or expensed. A "small business" was any business that

didn’t spend over $200,000 on such items for the year.

New $100,000 Limit. For 2003 a business may expense any or all of the first $100,000 spent on qualified equipment. A business is considered "small" if purchases are not over $400,000. In 2004 and 2005 these two numbers will be indexed.

Bonus Depreciation – 50%. Any business, large or small, can use this rule. It also applies to anything but real estate, but includes fixtures used in a rental. Unlike expensing rules, there’s an important date – it affects purchases on or after May 6, 2003 and runs through 2005. You write off 50% of the item’s cost right away – that’s the "bonus." In addition you then depreciate the remaining 50% over the normal life. Most business equipment falls into the 5-year life category. In this group, the new rules allow a full 60% of the cost to be written off in the first year.

Vehicles and Depreciation. Back in 1984 Congress invented a "luxury car" concept. They felt the vehicle deduction rules were being abused. Currently a car costing over about $15,500 is in this "luxury" class. For these vehicles there is a "cap" on the depreciation you may claim in each year. $50,000 cars get no more annual depreciation than $15,500 cars. To reflect the new "bonus" depreciation, the "caps" have been raised. The first year "cap" for cars is now about $10,700.

Larger Vehicles – No "Caps". Congress wanted to limit deductions on passenger cars while leaving business vehicles alone. A key rule says a "passenger auto" is a vehicle of Gross Vehicle Weight under 6,000 pounds. Gross Vehicle Weight (GVW) is a technical term. Each vehicle has its GVW printed on the sticker on the edge of the driver’s door. In 1984 our cars were smaller. Today monsters prowl the highways. Many SUVs and vans are well over the 6,000-pound limit. More than 35 production vehicles exceed the limit, but are used as family vehicles. They aren’t passenger cars – no caps apply.

Example. Picture an SUV worth $40,000. If the vehicle is used 80% for business you depreciate $32,000 of the vehicle’s cost. If this were a "passenger auto", you’d be limited to 80% of the luxury caps. Here are the deductions for the SUV and for a passenger car of the same cost.

You could even elect to expense any part of the $32,000 and depreciate the rest. The tax savings could exceed your down payment!

Warning: Such examples tend to get folks excited. I am not suggesting you should buy one of these vehicles. That’s a major economic decision I’ll leave to you. Moreover, depreciation is a two-edged sword. If you claim depreciation, you must report the eventual sale of the vehicle. Suppose you reduce an asset to Zero by using depreciation. If you sell for $10,000 a few years later you must declare a $10,000 gain.

Examples of Tax Savings. Here are some general examples. The incomes shown are total income – taxable income is always less. In all cases there are a few presumptions:

10% of total income comes from investments. Half of that investment income is from dividends and/or capital gain. Itemized deductions are 15% of total income.

Most people will be content to wait until they file their tax returns to get their savings. The Child Tax Credit resulted in $400 per child advance rebates in most cases.

If you pay estimated taxes, give me a call. It might be safe to trim your payments, but let me make sure you won’t be risking a penalty.

Wage earners should have noted a small increase in their paychecks in July. IRS issued new withholding charts to reflect the tax rate changes. This means part of your tax reduction (the savings caused by the rate changes) will be in your paychecks for one-half the year. You’ll get the other half when we file your return.

Investors. If you have large capital gains and/or dividends, you may see dramatic tax savings. Perhaps we should meet to talk about your situation.

The new laws change the way we must look at tax planning. But many strategies remain perfectly valid. Here’s an assortment of comments on the questions I hear most often.

Deductions involve spending money. Tax savings recover only part of the expense. If you don’t really need to spend the money – keep it. What are deductions worth? This depends on tax brackets. A typical couple today with one child can bring in about $80,000 before they reach the 25% tax bracket. Everyone has different deductions, but this "typical" couple has a tax bill around $8,000, and a $1,000 deduction saves about $150. By contrast, a couple in 1990 with the same income paid $14K-$15K in income tax, and a $1,000 deduction saved $280.

The good news – your tax bill is much smaller than just a few years ago. The bad news – deductions are not worth as much as they were.

Contributions. Many said low tax rates would reduce charitable giving. True, the deductions save less tax. But tax bills are lower. The relative values are quite similar.

Appreciated Stock. By the way, it still saves more to give an appreciated asset to charity than to sell the asset, pay your tax, and give the remaining cash to charity.

Retirement Savings. It still pays to sock money away for retirement. Lower tax rates reduce the up-front value of the savings, but waiting several years to pay your tax is still a great strategy. The only real change here is deciding the type of assets to hold in the accounts. Planners are continually changing the way they evaluate things. But the concept of saving for your future is more important than ever.

"Temporary" Laws. I’ve already said it. Congress intends the new laws to be changed. It’s probably safe to plan for 2003 and 2004 based on the new rules. Beyond that – who knows? In fact, it’s likely there will be a few changes before we file your 2003 returns! As I write this there’s a push to make the Child Tax Credits benefit more taxpayers.

Income-Shifting. A common strategy for wealthier folks is to shift tax burdens to family members in low tax brackets. Once you reach tax brackets of 25% or higher, it’s an attractive thought to move income to a child paying only 10% and 15%. Even small incomes shifted to save for college or a home purchase can have large rewards.

New capital gain rates add some kick. Only months ago if you had a $1,000 stock gain you faced up to a 20% tax. Giving the stock to a child might cause them a tax of only 5%. In doses small enough to avoid gift tax this is a powerful tax saver.