New Rate Cuts and Rebates

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By Roy Lewis
June 15, 2001

The backbone of the new 2001 Tax Act is the tax bracket reductions. But with virtually all things "tax," there have been a few complications thrown into the rate-reduction schedule. 

First of all, the rate cuts take place on July 1, 2001. Does that mean that you'll have to keep track of your income both "pre" and "post" July 1? Nope. The rate adjustment will be built into the tax tables, which will look like this, according the new legislation:

           28%  31%  36%  39.6%
2001-2003  27%  30%  35%  38.6%
2004-2005  26%  29%  34%  37.6%
2006-2010  25%  28%  33%  35.0%

For all intents and purposes, when the rate reductions are fully phased in come 2006, all of the existing brackets will be reduced by at least three percentage points. If you would like to see how the rate reductions will reduce your taxes over the years, you might want to drift over to this handy calculator created by CCH, Inc., one of the leading providers of tax information. Have your 2000 tax return in front of you, since you'll need to know your 2000 adjusted gross income and taxable income. 

You may have noticed in the above chart that the years only run to 2010. What happens after that? Unless the current or a future Congress decides to make these changes permanent, the law will revert back to what was in place immediately before the law change. In other words, tax rates will revert back to the old 28%, 31%, 36%, and 39.6% brackets. No joke. By doing nothing, the Congress could institute one large tax increase come 2011.    

Something missing? 
Many of you might wonder why the 15% rate wasn't discussed in the chart above. The reason is that there have been some pretty complicated things going on in the 15% bracket under the new law. And, in the age of tax simplification (an oxymoron, like "civil war" or "industrial park"), part of the 2001 Tax Act created a new 10% bracket. Seems reasonable so far, right? But let the confusion begin: The 2001 Act creates a new 10% bracket for years after 2000, but then wipes it out for 2001 and replaces it with a rate-reduction refund based on 2000 income, and/or, in some circumstances, a rate-reduction credit for the 2001 tax year.

Say again? 

Well, Congress wanted a rate cut to 10% at the lower end of the income scale for tax year 2001. But they also wanted to give taxpayers an immediate refund (since almost half of 2001 has already passed us by).  You've likely all heard about the "rebate" checks that we'll soon be receiving from Uncle Sammy, right? Those rebate checks are a part of this grand scheme. More on the rebate checks (officially called rate-reduction refund checks) later. Let's take a look at the new 10% tax bracket. 

The 2001 Tax Act taxes the bottom portion of your taxable income (called the "initial bracket amount") at 10% instead of 15%. For tax years beginning after 2000 and before 2008, the 10% tax bracket applies to:

  • the first $6,000 of taxable income for single individuals and married taxpayers filing separately;
  • the first $10,000 for heads of household;
  • the first $12,000 for married joint return filers and surviving spouses.

So let's do a bit of math. What's the difference between 15% and 10%? About 5%, right? So that 5% tax savings will apply to this lower end of the income spectrum. Multiply $6,000 (the initial bracket amount for single filers) by 5%, and you arrive at $300. Multiply the initial bracket amount for married filers by this 5% savings and you arrive at $600. Do the same for head of household filers and you arrive at $500. Do these amounts sound familiar? 

Now, after telling you all about the new 10% rate effective for 2001, I'm going to rock your world: The 10% rate will not appear on the 2001 tax rate tables that you'll use to prepare your 2001 tax returns. Instead, the benefit of the lower rate will be received through a credit/rebate mechanism in the Tax Act that's designed to put a refund check in the hands of eligible individuals (and a chicken in every pot) before October 2001.

That's right, the amounts that we computed above that represent the 5% rate reduction on the lower end of the income scale are nothing more than the rate-reduction refund checks that many of you will be seeing in the near future. Think of it as receiving some of your 2001 refund today, rather than waiting until sometime in 2002 when you actually file your 2001 tax return. 

You can think of it that way, but that's not really the way it works in practice. Why? Because the refund checks are being based upon your 2000 tax return. The refund check is computed as if for tax year 2000, a 10% rate was applied to your initial bracket amount, instead of the 15% rate. In other words, you're treated as if you had overpaid your 2000 tax bill in the amount to be refunded.

How about an easy example: Bill, a single person, had $6,000 of taxable income for 2000. He wasn't entitled to any credits and paid a $900 tax (15%). He will receive a refund check of $300. If he had only $4,000 of taxable income for 2000, did not claim credits, and paid $600 in tax, he'd get a $200 check (5% � $4,000).

Rate-reduction credits
So you can clearly see the problem: The refund checks are supposed to be for 2001, but will be computed on your 2000 income tax filing. That in itself is going to cause a lot of confusion. How about those folks who had very low income in 2000, but have much higher income in 2001? Will they miss out on part of their refund checks? Nope. They'll receive a rate-reduction credit when they file their 2001 tax return. So while they might have to wait a little longer for their full refund, the credit system worked into the 2001 tax forms will still give the full benefit of the rate reduction. 

Can't quite see how this works? Well then let's take Shirley, a single person. In 2000 she had $4,000 of taxable income and paid $600 in tax. In October 2001, she receives a rate-reduction refund check for $200 (5% of $4,000), rather than the "normal" $300. But in 2001 Shirley's prospects picked up. She had $20,000 of taxable income. She will be entitled to a $100 rate-reduction credit on her 2001 return (5% of the first $6,000 of income for 2001, less $200 rate-reduction refund) when she actually files it in early 2002.

Seems reasonable so far, eh? Then think about this: What will happen to those people who had taxable income in 2000, but dropped off of the income radar screen in 2001? They likely received the full refund check, based on their 2000 income. Will they be forced to repay this refund to Uncle Sammy? The law says no. And the same holds true for any folks who find that their rebate check, based on their 2000 tax return, was greater than what would have been allowed based upon actual 2001 income. Consider the person who passes away in early 2001, having no taxable income for 2001. But that person had plenty of taxable income in 2000. Would that person have to repay the refund check that they actually received? Not at all. It's another harsh (but legal) way of beating the system. 

So if you receive the maximum refund check allowed by law, enjoy it. Regardless of what happens to your 2001 income, you won't have to give it back. But if you receive a refund check in an amount less that the law allows (or receive NO refund check), make sure that you complete the worksheets that will be provided with your 2001 tax forms and instructions to see if you can get some or all of your remaining refund in the form of a rate-reduction credit on your 2001 tax return.

Don't just assume that Uncle Sam was correct in giving you a refund check of $50 when you were expecting $300. It's quite possible that Uncle Sam was correct based upon the 2000 tax year data, but your situation has changed and you now get the remainder of your refund in a 2001 refund credit.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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