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Taxes: What They Mean to You

Federal tax legislation enacted in recent years has affected virtually all Americans, with major changes in income tax rates, taxes on dividends and long-term capital gains, estate taxes, retirement savings rules, and education incentives. Some tax changes have already taken effect while others will phase in throughout the decade. Also, the tax legislation contains "sunset provisions," which means some laws will expire after December 31, 2010, unless Congress renews or changes them.

Keep in mind that federal legislation entails myriad details, and the following represents only a summary of the principal provisions.1

Reduced Income Taxes
The table below lists current federal income tax rates. In addition, a 10% tax bracket applies to the first $16,700 of income earned by a married couple in 2009. For singles it applies to the first $8,350. After December 31, 2010, previously written tax rules will again take effect.

New Rates on Ordinary Income
Previous Rate Current Rate

38.6%
35%
30%
27%

35%
33%
28%
25%

Dividends and Capital Gains
Dividend income paid by U.S. and some qualified foreign corporations is now taxed at a top rate of 15%. Previously, dividend income was taxed as ordinary income, with rates running as high as 38.6%. The 15% rate is scheduled to expire after December 31, 2010. If it expires as scheduled, dividends will again be subject to prevailing income tax rates.

Be aware that some types of dividend income may not be included in these rules. For example, dividends received from a REIT (real estate investment trust) may not be subject to the new tax rates. Please check with your tax advisor for the various types of dividend income that are exempt from the new rules.

The legislation also reduced the top tax rate on long-term capital gains (gains on assets held more than one year) from 20% to 15%. The new tax rate applies to gains realized after May 5, 2003, and is scheduled to expire after December 31, 2010.

Relief for Parents and Joint Filers
As a result of the 2003 legislation and subsequent extension in 2004, parents of children under age 17 can claim a child tax credit of $1,000 per child through 2010. The credit begins to phase out for single filers and heads of household with adjusted gross incomes of $75,000 or more, married couples filing jointly with incomes of $110,000 or more, and married individuals filing separately with incomes of $55,000 or more.

For married couples who file jointly, the tax legislation attempts to reduce the impact of the so-called marriage penalty: a glitch in the tax rules that results in higher tax bills for some married couples than they'd face if they were single and filing separately. The 15% tax bracket for married taxpayers filing jointly was expanded so that it applies to twice as much income as for single filers. In addition, the standard deduction for joint filers was increased so that it will be double that allowed for single filers.

These new rules are scheduled to expire after December 31, 2010.

Alternative Minimum Tax Exemption
For married couples filing jointly, the alternative minimum tax exemption is $69,950 in 2009. For single filers, it is $46,200 in 2009.

The alternative minimum tax is a federal tax system created in 1969 to help ensure that wealthier taxpayers didn't use loopholes to completely avoid paying income taxes. But because the tax was never indexed for inflation, it has increasingly applied to less affluent households.

Retirement Savings Vehicles
A number of tax changes benefit those saving and investing for retirement, including:

Higher Contribution Limits
- The limit on annual contributions to traditional and Roth IRAs is $5,000. For certain employer-sponsored retirement plans - including 401(k) plans - the annual contribution limit in 2009 is $16,500. Keep in mind, however, that employers can impose contribution limits that are lower than the government maximum.

Contributing the Max
 Tax Year
401(k) and 403(b)
[traditional and Roth]
457 Plans

Simple Plans
 2009  $16,500 $11,500

Catch-Up Provisions for Those Nearing Retirement - Individuals aged 50 and older can take advantage of "catch-up" contributions to IRAs and some qualified employer-sponsored retirement plans. For IRAs, the allowable catch-up contribution is $1,000 per year. Participants in 401(k) and certain other qualified employer-sponsored plans who are at least 50 years old are also permitted to make catch-up contributions of $5,500 in 2009 and adjusted annually for inflation thereafter. Participants in SIMPLE Plans who are aged 50 and older can make a catch-up contribution of $2,500 in 2009 and will be indexed to inflation thereafter through 2010. Before investors can make catch-up contributions, they must first make the maximum regular contribution to their IRA or employer-sponsored plan.

Estate Taxes
Tax legislation passed in 2001 increased the federal estate tax exemption, reduced the estate tax rate, and will repeal the entire estate tax for the year 2010. In addition, the 2001 tax act capped the lifetime gift tax exemption at $1 million. After 2009, the top gift tax rate will be the same as the top individual income tax rate. Over time, these changes will have a dramatic impact on higher-net-worth individuals seeking to pass more of their wealth to their heirs. Bear in mind that since 2001, many states have enacted or modified their own estate tax rules in response to these changes.  

Federal Estate Tax Exemption and Estate/Gift Tax Rates
Tax Years
Estimated Tax Exemption
Highest Estate and Gift Tax Rates
2009 $3.5 million
45%
2010 Estate taxes repealed
Maximum gift tax rate will be top individual income tax rate (35%)
2011 and beyond, unless Congress acts to change Pre-2001 rules apply

Education Incentives
Following is a summary of tax changes since inception of certain tax benefits for those saving for education. Note that certain education tax credits and deductions not discussed here have also been modified. Contact your tax or financial advisor for more information concerning those provisions. 

Coverdell Education Savings Accounts (formerly Education IRAs)  

  • Maximum annual contributions increased from $500 in 2001 to $2,000.
  • Qualified withdrawals are now eligible to be used to fund elementary and secondary education in addition to higher education expenses.
  • The income eligibility limits for Coverdells were raised for joint filers. The phaseout range is now $190,000 to $220,000, up from $150,000 to $160,000 in 2001.
  • The contribution deadline for Coverdells changed from December 31 each year to April 15 of the following year.
  • Age limits for contributions and withdrawals don’t apply to special needs beneficiaries.
529 Plans
  • Qualified distributions from 529 plans are now tax free. Formerly, participants in 529 plans enjoyed the benefit of tax deferral.
  • Investors may now transfer assets from one 529 plan to another on behalf of the same beneficiary without paying taxes on the distribution.

Take the Next Step: Talk to a Pro
Tax legislation often takes time to sort out - particularly when there are as many sunset rules as there are in the recent tax acts. To be sure you understand the rules and how they apply to your situation, work with your financial and tax professional.

1Source: Internal Revenue Service, 2007.

Points to Remember

  • Tax changes accelerate rate reductions on ordinary income. The top rate is now 35%.
  • Rates on dividends paid by domestic and some qualified foreign corporations were reduced to a top rate of 15%.
  • The top tax rate on long-term capital gains was lowered from 20% to 15% for sales of assets after May 5, 2003.
  • The child tax credit on dependent children younger than 17 was raised to $1,000 effective through 2010.
  • The legislation contained a variety of sunset provisions, and some rules will expire by January 1, 2011, unless Congress extends them.

This article is not intended to provide specific investment or tax advice for any individual. Consult me, your financial advisor, or your tax advisor if you have any questions. 

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