LOISELLE, GOODWIN & HINDS
CERTIFIED PUBLIC ACCOUNTANTS

Questions & Answers About Inflation Adjustments to Tax Figures

[However, Please see our Discussion of the Changes made by the Jobs and Growth Tax Relief Reconciliation Act of 2003]

Question. Do the tax rates go down in 2003?

Answer. No. The tax rates for individuals stay at 10%, 15%, 27%, 30%, 35%, and 38.6% in 2003. The top four brackets will drop by a full percentage point in 2004 and there’s a further reduction scheduled for 2006. There is some tax relief, however, 2003 in the form of inflation adjustments to the tax brackets and other items.

Question. How do the inflation adjustments work?

Answer. The point at which each of the top four tax brackets begins is increased for inflation each year. This means that, in 2003, more income will be taxed at 15%, 27%, 30% and 35% than in 2002. The adjustments for 2003 are based on the CPI figure for August 2002 and the figures for the 11 prior months going back to September 2001.

Question. Are other income tax items adjusted for inflation?

Answer. There are numerous other income tax items that are adjusted for inflation including, for example, the standard deduction and the personal exemption amount. In 2002, the exemption is $3,000. It will increase to $3,050 in 2003. Likewise, the basic standard deduction for a married couple filing jointly is $7,850 in 2002. It will be $7,950 in 2003. Standard deductions for single taxpayers and other filing status also generally will increase for 2003.

Question. Do all of the items that qualify for adjustments get at least some increase?

Answer. No, that’s because the technical way in which adjustments are made varies for different items. For example, different items have different rounding mechanisms. Many adjustments are rounded down, which could result in no increase for a particular year.

Question. What kind of the tax savings will be realized in 2003 from the adjustments?

Answer. Let’s look at a two-wage-earner couple with two children. Assume they have gross income of $120,000, $30,000 of itemized deductions, and taxable income of $78,000, after taking into account their four $3,000 personal exemptions. Their tax bill for 2002 comes to $14,856. If their income stays at exactly the same level for 2003, their tax bill will go way down to $14,712, for a savings of $144. The savings would be exactly the same if the family had taxable income of $50,000. However, on taxable income of $200,000, the savings would be $282.

Question. Do any taxpayers not benefit from inflation adjustments?

Answer. The 10% bracket is not presently increased for inflation. So someone in the 10% bracket for 2002 who earns a little more in 2003 can be pushed into the 15% bracket on account of inflation. The law itself calls for a widening of the 10% bracket in 2008. Someone in the 10% bracket can, of course, benefit by the inflation adjustments to the standard deduction and exemption amount. Also, the AMT can rob individuals of the benefit of inflation adjustments because the AMT is not adjusted for inflation.

Question. What is the AMT?

Answer. We actually have two income tax systems--the regular tax and the alternative minimum tax or AMT, which is designed to prevent taxpayers from paying too little tax. It does that by disallowing or reducing certain deductions and treating as income certain items that are exempt from regular tax. If an individual’s AMT exceeds his regular tax, he pays the difference plus his regular tax. So let’s say for 2002 an individual’s regular tax is $30,000 and his AMT also is $30,000. He pays $30,000 in regular tax. Now, for 2003, inflation adjustments push his regular tax down by $200. His AMT is still $30,000, because it’s not adjusted for inflation, so he ends up still having to pay $30,000. In other words, the AMT robs him of the $200 benefit from the inflation adjustment.

Observation: The family of four with gross income of $120,000 form the example above showing the benefit from the inflation adjustments could actually be subject to AMT depending on the make-up of their itemized deductions and other factors. For example, if only $13,000 of their itemized deductions were deductible for AMT purposes their total tax including AMT would be $15,080.

Question. Are the monthly amounts that an employee can exclude from income for transit passes and parking under a company program increased?

Answer. The $100 limit for transit passes will stay at the level for 2003. However, the parking limit will go from $185 per month in 2002 to $190 in 2003. Employees of companies who offer these benefits can save income tax. In addition, social security taxes can be saved by employees whose wages are not over the social security wage base ($84,900 for 2002, $87,000 for 2003) and by employers with respect to such employees.

Question. How is the luxury auto excise tax impacted by inflation?

Answer. There’s good news here. For 2002 purchases, the tax is 3% of the purchase price in excess of $40,000. There’s no inflation adjustment in 2003 but that’s because the tax doesn’t apply to purchases after 2002. So I you are thinking of buying a luxury car, waiting to do so until 2003 will save you tax money.

Question. What other key adjustments are there?

Answer. There are some other important adjustments that affect individuals with incomes at higher levels. Many tax breaks are reduced or eliminated as income exceeds certain thresholds including, for example, itemized deductions, exemptions, and education tax breaks. These thresholds are increased for inflation. This means that fewer individuals will lose some of these tax breaks and the amount that will be lost will be lessened unless they get additional income next year that pushes them over the higher levels.

Question. What can be done to avoid losing tax breaks when income starts approaching the thresholds at which tax breaks are reduced or eliminated?

Answer. Individuals whose income is close to the threshold amount for a particular item may be able to take some steps to keep income below the threshold. A couple may know they are going to be over next year but may be able to keep below the threshold this year by taking certain steps. For example, it may be possible to reduce this year’s income by pushing a bonus into next year, moving money from taxable interest bearing amounts to tax-exempt accounts, increasing 401(k) and IRA contributions, and selling stock at a loss. An individual who would be over the limit this year but who might not be next year, should consider the opposite type of planning moves, i.e., accelerating income into this year and deferring above-the-line deductions until next year.

Question. What would happen to the tax figures if we had deflation next year?

Answer. Technically, the way the statutory provisions work, if we had deflation next year, it appears that the 2004 figures could go down from the 2003 figures.

Question. What do the adjustments all mean for individuals?

Answer. The inflation increases are low and thus the tax savings from the adjusted figures are low. Individuals can’t figure on a whole lot of savings next year from the inflation adjustments. However, there are several new tax rules that first apply this year and next year. For example, the amount that can be placed in a Coverdell education savings account (formerly education IRA) is increased to $2,000 from $500, there’s a new above the line deduction for higher education expenses ($3,000 maximum), the amount that can be contributed to an IRA is increased to $3,000 from $2,000, an additional $500 can be contributed to an IRA by qualifying individuals age 50 and over, the amount may be contributed to a 401(k) plan is increased to $11,000 for 2002 ($12,000 for 2003) and employers can allow those 50 or over to contribute an additional $1,000 for 2002 ($2,000 for 2003), to name a few.

(9/26/02)

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Last modified: June 13, 2003