Tax Rebate Math and the Estate Tax Trojan Horse

This week, Gail explains the political and psychological underpinnings of the new tax refunds -- and tries to tame the Estate Tax Trojan Horse.

Hi, Gail

I hope you can clear up some confusion about the lower tax rates and how they relate to the refund checks we're supposed to be getting later this year.

I thought the lower 10% rate was retroactive to Jan. 1 and that's why I was getting a check for $300 as a single filer. But everything I read says this new, the lower rate starts on July 1. So where's the $300 coming from?



Dear Tom,

This is one of those times when a tax benefit comes at the cost of some complexity. Congress wanted the new, lower tax rate of 10% (see below) to apply to your entire 2001 income. So they made that new rate effective retroactive to Jan. 1. Congress made reductions in other tax rates (i.e., the 28% through 39.6% rates) effective as of July 1, 2001, however.

In any event, you're right that tax credit you can probably expect to receive in the next few months is the result of the retroactive 10% tax rate.

Here's the way it works: Because the IRS doesn't know your tax liability for 2001 yet, it is computing the amount of the credit you receive based on your 2000 tax return. Then, when you fill out your 2001 tax return next year, you will have to calculate the amount of the credit you should have received based on your 2001 tax bill.

For most of us, the amounts will be the same. But, if for example you paid no tax in 2000 (and thus didn't get a tax credit check this year) but owe tax in 2001, you can claim the credit against your actual taxes for 2001. At the other extreme, if you retired at the end of last year and have NO taxable income this year, you will receive a refund check anyway.

So why go to all this trouble anyway? It all becomes clear when you remember the "Two P's" of Washington: Politics and Psychology. By next April 15, most of us will have forgotten about this year's tax cut. After all, in the total scheme of things, $300, $500 or $600 less in taxes might just get lost in the math.

No Sirree, instead, your elected officials in Washington want you to get a special refund check so you remember those who made it possible! (And you can bet, even if he/she didn't vote for the bill, they'll take credit for the refund.)

And don't forget they also want to pump some extra cash into consumers' pockets ASAP in order to help jumpstart the sluggish economy. If the impact of this reduced rate were not felt for nearly a year, who knows what shape the economy would be in by then?

The Treasury Department will start mailing out checks this summer based on the last two digits of your Social Security number. (If there is more than one filer, they'll use the Social Security number of the person listed first on your return.) The goal is to have all the checks mailed by Oct. 1, putting an extra $55 billion into the hands of consumers who, it is hoped, will dutifully march to the closest shopping mall or car dealer and spend it.

Please don't shoot the messenger,


Dear Gail -

I take it from your latest column that you think this new tax bill is terrific for everyone. However, I'm retired from being self-employed and I finished putting my kids through college years ago. I might be missing something, but my basic question is: "What's in this for me and my husband?"


Dear Joyce,

I completely understand where you're coming from. The Economic Growth and Tax Relief Reconciliation Act of 2001 does contain a lot of provisions aimed at those who are still in the workforce as well as folks concerned about paying for a child's college education.

Clearly, if you're retired and have already paid for college, you cannot take advantage of these tax breaks. However, this is a huge bill and it does contain tax breaks that you and your husband can take advantage of.

For starters, there is the new, lower tax rate of 10% on the first $12,000 in income you have this year. Instead of paying $1,800 in tax on this portion of your income, you will owe $1,200 -- a saving of $600. That's why married couples will be receiving a check for this amount in early fall. (Single tax filers will receive a check for $300; heads of households will get $500.)

I don't know what income tax bracket your and your husband are in, but all, the others are slated to drop as well. The result is that by 2006, today's 28% bracket will fall to 25%, the 31% bracket drops to 28%, 36% declines to 33% and the highest tax rate drops from 39.6% to 35%. Unless you two are living on $12,000 or less, you will definitely benefit from these lower brackets as well.

And the "marriage penalty" will gradually disappear. Right now, two people who are married do not get TWICE the standard deduction as a single tax filer. But this will no longer be the case by 2008. By then, two people who file as "married" will get the same total standard deduction as if they had each filed as "single."

Furthermore, while I hope the two of you live long and prosper, starting next year you'll be able to leave more to your children and grandkids free of estate tax. This year, the maximum you can leave a non-spouse estate tax-free is $675,000. That was scheduled to rise to $700,000 in 2001.

However, the new law bumps that increase to a million dollars. If Congress keeps its hands off the provisions in this act, the exempted amount will continue to increase until the estate tax completely disappears by 2010.

Eliminating the estate tax comes with a hitch: your heirs will no longer inherit your assets at their current value and benefit from the so-called "step-up" in the cost basis. Instead, your heirs will assume the same cost basis you had. For instance, let's say you bought 10,000 shares of XYZ stock for $5/share back in 1970 and when you die, they're worth $50/share.

Under the existing law, your heirs would be able to use the current price of $50/share as their cost basis. If they sold the stock for $54/share, they would only report capital gains of $4 x 10,000 shares = $40,000.

However, once the estate tax is fully repealed, your heirs would have to "carry over" your cost basis in the stock of $5/share. Using this to compute the gain results in a profit of $49/share. If they sold all the stock, they would have a capital gain of $490,000.

But Congress isn't entirely heartless -- or stupid. (After all, members of the House and Senate also stand to be on the giving and/or receiving end of inherited assets!) So the new law provides a "limited" step-up. Non-spouses will be allowed to use the stepped-up cost basis on up to $1.3 million worth of assets. A spouse would get a more generous step-up of up to $4.3 million. But amounts over these would be subject to the new rules applying the decedent's original cost to calculate the gain.

By the way, if you have any interest in helping your grandchildren pay for college, the tax breaks I covered last week also apply to grandparents!

Take care-


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The views expressed in this article are those of Ms. Buckner or the individual commentator, and do not necessarily reflect the views of Putnam Investments Inc. or any of its affiliates. You should consult your own financial adviser for advice regarding your particular financial circumstances. This article is for information only and is not an offer of the sale of any mutual fund or other investment.