The EGTRRA (and JAGTRRA) sanction
By Brad and Bob

Dear Brad and Bob:

In your books and columns you advocate tax planning as the best way for “smart frogs” to save money. In 2001, Congress passed EGTRRA, and they recently passed JAGTRRA. What should the smart frog be doing now?

--Cody P., Pittsburgh
 

Brad: Let’s start with a bit of background information, Cody, so we can put tax-smart planning in the proper context. First, EGTRRA stands for the Economic Growth and Tax Relief Reconciliation Act, which was passed and signed into law in 2001. Among other things, EGTRRA increased the annual amounts people could sock away in voluntary retirement plans such as 403(b)s and 457s, and created a new 10 percent income tax bracket. It also began a phase-in of some reductions in the highest four tax brackets. That phase-in was to take place in steps  between now and 2006.

Bob: Now, JAGTRRA (the Jobs and Growth Tax Relief Reconciliation Act of 2003) passed and signed into law earlier this year, has been imposed on EGTRRA. The new law was presented to the public as a short-term package designed to stimulate the U.S. economy. It does this by accelerating the EGTRRA reductions in tax rates, making them all effective retroactive to Jan.1, 2003. So, on that date, the 38.6 percent bracket dropped to 35 percent, the old 35 percent bracket fell to 32 percent, the former 32 percent bracket was cut to 28 percent, and finally, the 27 percent bracket was reduced to 25 percent. Got that?

Brad: The 15 percent and 10 percent brackets weren’t cut at all, but expanded so that they would apply to more taxpayers. JAGTRRA also temporarily increased the Child Tax Credit from $700 to $1,000 for tax years 2003-04.

But more important, it reduced long-term (owned more than 12 months) capital gains taxes on the sale of certain assets from a maximum of 20 percent to 10 percent, and (for lower-income taxpayers) from a maximum of 10 percent to 5 percent for 2003 through 2007. JAGTRRA also permits owners of corporate stocks and mutual fund shares to treat dividend payments as long-term capital gains. Under the prior law, these gains had a maximum tax rate of 38.6 percent. Under the new law, the maximum tax now is 10 percent and possibly only 5 percent in 2003 for those in the lowest tax bracket.

Bob: So, Cody, there are a number of things for smart frogs to consider. First, if possible, one would like to adopt strategies that the new law favors, such as investing for long-term capital gains and avoiding any strategy that results in short-term gains—“day trading,” for example. Second, one also should take note of the lowered taxes on dividends and invest in stocks and mutual funds with a history of paying solid dividends. The rule is that for a dividend to receive favored tax treatment as a “capital gain,” the investor must own the shares for at least 60 days in the 120-day period beginning 60 days before the shares go “ex-dividend.”

Sound confusing? Well it is just another way of discouraging short-term trading. One has to purchase and hold shares to get the special tax rate. Finally, smart frogs need to rethink whether they want to continue using tax-sheltered accounts like 403(b)s. It might be smarter with the lower rates to pay taxes now and invest in Roth IRAs.

Brad: Now, here’s where things can get very tricky for smart frogs. We call it the EGTRRA Sanction. What’s the story? Both EGTRRA and JAGTRRA contain “sunset provisions” that begin to eliminate the special tax breaks contained in both laws starting in 2009.

And unless Congress acts to extend them, on Jan. 1, 2011, everything will revert to pre-2001 law. So the smart frogs need to be mindful that the strategies they employ to minimize taxes now could actually backfire on them in the future.

AFT members Brad Glanville and Bob Fischer are professors at California State University, Chico, and authors of Educators’ Tax Guide 2004 Edition, which locals can purchase at volume discounts. Contact the authors at Tax Talk, c/o ETPS, 2260 St. George Lane, Suite 5, Chico, CA 95926, e-mail etps@aol.com.