(Investor Perspective is a quarterly publication of American Century Investments. This article appeared in the Summer/Fall 2001 issue.)
The Tax Relief Act of 2001:
What the New Laws Mean to You
By Rod Perlmutter, Financial Writer
Investor Perspective: Summer/Fall 2001 Issue
You’ve probably received your income-tax rebate check in the mail, courtesy of the Tax Relief Act of 2001. If receiving a check from Uncle Sam for several hundred dollars felt good, you may feel even better when you learn about other provisions in the new tax laws that can save you thousands.
Signed into law on June 7, 2001, the Tax Relief Act lowers some tax rates and increases the amounts investors may contribute to various government-sanctioned tax-deferred savings plans, including Individual Retirement Accounts (IRAs), 401(k) and 403(b) plans. The Act also broadens the rules governing how parents can sock away money for a child’s education.
As always seems to be the case with the tax code, some of the new rules are complicated. Here’s closer look at how a few features of the new tax law may affect the way you invest.
Saving for retirement
Investing in an employer-sponsored retirement plan has always been a smart move, and starting in 2002, you can invest even more. Until this year, investors’ contributions (including employee contributions and employer-matching and profit-sharing contributions) to employer-sponsored retirement plans were capped at $30,000 or 25% of compensation (whichever was less). Under the new law, your contribution can be the lesser of $40,000 or 100% of compensation.
IRAs just got better, too. Under the old tax law, investors could put away up to $2,000 annually. But two decades of inflation have eaten away at the original value; $2,000 in 1981 dollars is worth only about $1,440 in 2000 dollars. To offset the effect of inflation, the new law raises the maximum annual contribution limits gradually, from as much as $3,000 starting in 2002, to $4,000 in 2005 through 2007, and then to $5,000 in 2008. After that, the limit may be increased annually in increments of $500, depending on inflation.
If you get a late start saving for retirement, depending on your age, the new tax law may have a special provision for you. Beginning next year, investors 50 years and older will be able to make “catch-up” contributions to their IRAs and employer-sponsored retirement plans. Such “senior” IRA investor can contribute an additional $500 annually from 2002 through 2005, and up to $1,000 more per year starting in 2006. (For example, in 2002, a 50-year-old investor can invest up to the maximum annual limit of $3,000 plus $500 as a catch-up contribution, for a total of $3,050. (See chart.)
Investors in 401(k) and other employer-sponsored retirement plans can make additional catch-up contributions in increments rising from $1,000 in 2002 to $5,000 in 2006.
Greater control and flexibility
Under the previous tax code, investors were largely restricted from commingling assets of different plans – an IRA and a 401(k) to which they were currently contributing, for example. But the new tax laws remove these barriers between plans. Beginning in 2002, if the plans allow it, you can move assets from most types of employer-sponsored retirement plans into another plan (for example, from your previous employer’s plan to your new employer’s) or into your IRA – or, in some cases, even from your IRA into your employer-sponsored plan. In addition, any matching contributions your employer makes to your plan may vest sooner.
Investing for education
Other attractive changes in the new tax law pertain to the two main tax-deferred vehicles used to save for education costs – “529 plans” and Education IRAs.
The 529 plan (also known as the Qualified Tuition Program) lets families invest thousands of dollars annually in a state-administered education fund with tax-deferred earnings growth. (Learning Quest, the 529 plan administered by the state of Kansas, is managed by American Century.) Currently, 43 states offer, or are about to offer, 529 plans.
Originally, when funds were withdrawn from a 529 plan to pay for college, the money was taxed at the student’s tax rate. But under the new law, qualified withdrawals will be free from federal income tax beginning in 2002. For many families, this can translate into thousands of extra dollars.
Similarly, investors can save more money through an Education IRA, now known as the Coverdell Education Savings Account. Since 1998, families investing for a child’s college fund have been able to make tax-deferred contributions into an Education IRA. But annual contributions were limited to $500, and were available only to married couples filing jointly with an adjusted gross income of less than $160,000.
Starting in 2002, the annual contribution ceiling increases to $2,000, and the income level maximum increase as well, on a sliding scale that enables those with lower incomes to contribute more. For example, a married couple with adjusted gross income of $190,000 or less can contribute up to $2,000, while a couple with an income of $205,000 can contribute only $1,000.
In addition, where Education IRA proceeds could once be used only for college expenses, starting in 2002, these funds can be used for elementary and secondary school expenses as well.
Also, under the new law, families will be able to save using both a 529 plan and a Coverdell Education Savings Account/Education IRA in the same year for the same beneficiary.
Strike while the iron is hot
The Tax Relief Act is the largest tax cut in a generation, estimated at $1.35 trillion over 10 years. Debate over its size and scope led Congress to impose a “sunset” clause – a deadline that dictates that all provisions of the law will end on January 1, 2001, unless extended by future legislation.
Ten years may sound like a long time, but when it comes to investing, it’s never too soon to take action and make your long-term plans.
As American Century’s founder Jim Stowers says in his book, Yes, You Can…Achieve Financial Independence: “The best time to plant an oak was 20 years ago. The second-best time is now.”
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This information is for educational purposes only. It is not intended as investment advice.
Investor Perspective is a quarterly publication of American Century Investments, an investment services company based in Kansas City, Mo.
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