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What the 2001 Tax Act Means for Academics

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By Douglas A. Rothermich

Tax and estate planning is not usually the most popular course on campus, but it is one that professionals in higher education should at least audit. The comprehensive tax law enacted last June has real-world consequences for people employed in education and research, and creates important opportunities and challenges.

The changes I'll talk about here affect academic employees who are covered either by 403(b) plans (tax-deferred retirement plans available to employees of educational institutions and certain nonprofit organizations) or by 457(a) retirement programs (deferred-compensation plans aimed at states and other government entities).

Just keeping a few basic points in mind about the changes can help you and your family enjoy a more comfortable and financially secure future.

Income Tax Planning

While the tax law has received a lot of media coverage, it is useful to recap a few key details. The income tax rate changes will benefit most taxpayers -- although to varying degrees. Individual income-tax rates previously ranged from 15 percent to 39.6 percent, but will drop, under the new law, to between 10 percent and 35 percent over the next five years. There is an immediate drop this year for a portion of the lowest tax bracket to the new 10 percent rate. This retroactive decrease resulted in the tax-refund checks that many taxpayers received over the last several months. All other brackets are being reduced between July 1, 2001, and 2006. By the latter year, the top four old tax brackets will be lowered to 25 percent, 28 percent, 33 percent, and 35 percent.

Following this gradual reduction in income tax rates, taxpayers with higher incomes will also see some easing of the limitations on itemized deductions and personal exemptions beginning in 2006. The lower tax rates, combined with increased itemized deductions and personal-exemption amounts, should generally reduce income taxes for some taxpayers.

But before you start planning new uses for those tax savings, beware of the Alternative Minimum Tax (AMT). Originally designed to prevent wealthy taxpayers from escaping income taxes through the use of exclusions, deductions, and credits, the AMT may also snare many less-affluent taxpayers. AMT is computed on the basis of your regular taxable income; from that figure, certain items are either added back or deducted, such as state and local taxes, personal exemptions, miscellaneous itemized deductions, and any incentive stock options where the option price paid is below the fair market value of the stock. For many people, the income-tax savings generated under the new tax law will be canceled out by higher amounts subject to the AMT -- particularly taxpayers in states with high state income or property taxes. The lower income tax brackets will reduce many taxpayers' "regular" tax liability below their AMT liability; the IRS collects the higher of the two amounts. Projections prepared by the U.S. Joint Committee on Taxation estimate that the number of taxpayers subject to the AMT by 2010 will more than double to over 35 million. The only way to determine if you will be one of the millions is to do the math. (You can find helpful information about AMT on SmartMoney.com and The Motley Fool, two of the many Web sites on personal finance.)

One area to consider for investing some of the income-tax savings you may realize from this new law is in your Individual Retirement Account or other tax-deferred retirement accounts. This year's tax act increased the amounts that can be set aside in these accounts.

New Limits for 403(b) and Other Plans

The new tax law offers numerous incentives for retirement savings. Many of these incentives are in the form of higher contribution limits and tax-favored saving options. Beginning in 2002, the limit for pre-tax contributions to 403(b), 457(a) or 401(k) plans will be increased to $11,000 (from $10,500 this year), and will rise by $1,000 a year thereafter through 2006, when the maximum pre-tax contribution will equal $15,000. After 2006, the maximum amount will be indexed for inflation.

At age 50 or older, the new law also includes a "catch-up" provision that may allow people to make additional pre-tax contributions to their retirement plans, above the annual limit. The catch-up amount will be an additional $1,000 in 2002, increasing by $1,000 a year through 2006 (when the catch-up amount will equal $5,000). Larger contributions will of course generally lead to larger retirement accumulations.

The maximum contribution limits for an IRA are also increasing. The current maximum of $2,000 a year will be gradually increased to $5,000 by 2008. A modified version of the catch-up provisions described above will also apply to IRAs -- but with lesser amounts until 2005, and larger amounts thereafter.

Based on the new tax law, here are a few tips academics should consider:

• Project your estimated income and deductions during the next few years, focusing on which items you can control by either the timing of when you report them for tax purposes, or the amount you report. For example, it will probably be to your benefit to maximize deductions in a year when you know your income is slated to rise, perhaps through a bonus or a payment for a special consulting assignment, pushing you into a higher tax bracket.

• Take advantage of the opportunity to set aside more income in tax-deferred retirement plans.

• Consider ways to accelerate your deductions, taking them in earlier years when higher marginal tax rates are in effect (e.g., accelerating charitable gifts before year-end to allow the deduction this year).

• Don't assume that the little-understood AMT will not affect you. Meet with your accountant to prepare future tax estimates, which must include projected AMT liability. Knowing how your income tax will be calculated will allow you to plan more effectively.

Estate Planning

Like Mark Twain's death, reports of the demise of estate taxes are greatly exaggerated. For many people, the new law could provide eventual relief from the estate tax, but that relief could be fleeting -- making it very difficult to understand today how you should plan your affairs.

Beginning in 2002, the amount of your estate that is exempt from the estate tax increases steadily from the current level of $675,000. During 2002-3, the amount increases to $1-million; then to $1.5-million in 2004-5; $2-million in 2006-8; and $3.5-million in 2009. Finally, in 2010, the estate tax is repealed (satisfying many campaign promises). However, complete relief may be short-lived. The tax law is schedule to expire after 2010, and tax laws in place before this year's new law will be resurrected. Following the new law's "sunset," the estate tax returns to the level it would have been before this year's change, putting the 2011 exemption amount at $1-million.

The rise in the amount of your estate that is exempt from the estate tax will be accompanied by a drop in the rate at which the remainder of your estate will be taxed. The maximum estate-tax rate (currently 55 percent) will gradually drop to 45 percent by 2007, only to revert back to 55 percent after 2010.

However, the act creates one other area of uncertainty: Many states collect their own estate tax, usually equal to the amount of the federal tax credit you get for paying state death taxes. If your state's estate tax is tied to the federal tax credit, that linkage does not increase the total estate taxes you pay; rather, it simply reallocates some of the federal tax to your state through the state death-tax credit. Within four years, the new law reduces to zero the federal tax credit allowed and replaces it with a general deduction for state estate taxes paid. For a state using the federal credit to define the amount of its estate tax, the state estate tax will go to zero unless state officials impose a different form of estate tax. The impact on state treasuries obviously could be dramatic and may cause legislatures to revise how an estate is taxed at the state level, resulting in higher combined federal and state estate-tax rates.

The new law creates great uncertainty for estate-planning purposes. Congress needs to provide clearer direction on the eventual application of the estate tax. If that direction is a decade in coming, the need to plan for the estate tax is not going away anytime soon. In the meantime, here are a few things to consider:

• Make sure you update your existing estate plan to reflect changes in the new law, and coordinate these changes with the beneficiary designation in your retirement accounts and life-insurance policies.

• Discuss with your lawyer how your plan should be amended to ensure the greatest flexibility in the future, while still capturing the benefits under the current tax system if your death occurs in the near term.

• Don't assume that higher exemption amounts mean that you need not consider tax planning in your estate plan. Given the uncertainty about the permanence of the new tax law, you should review your estate plan periodically.

I've touched on some of the important implications of the new tax measure, but there are others, including major enhancements made to education-savings vehicles like state-sponsored college-savings plans and the Education IRA. These can be important in helping families save for their children's higher education, so you may want to speak with an accountant or investment planner.