[Background Material and Data on Programs within the Jurisdiction of the Committee on Ways and Means (Green Book)]
[Program Descriptions]
[Section 13. Tax Provisions Related to Retirement, Health, Poverty, Employment, Disability, and Other Social Issues]
[From the U.S. Government Printing Office, www.gpo.gov]
SECTION 13 - TAX PROVISIONS RELATED TO RETIREMENT, HEALTH, POVERTY,
EMPLOYMENT, DISABILITY AND OTHER SOCIAL ISSUES
CONTENTS
Introduction
Net Exclusion of Pension Contributions and Earnings
Individual Retirement Arrangements
Exclusion of Social Security and Railroad Retirement Benefits
Exclusion of Employer Contributions for Medical Insurance Premiums
and Medical Care
Tax Credit for Health Insurance of Eligible Individuals
Medical Savings Accounts
Health Savings Accounts
Cafeteria Plans
Health Care Continuation Rules
Group Health Plan Requirements
Tax Benefits for Accelerated Death Benefits and Long-Term Care
Insurance
Deduction for Health Insurance Expenses of Self-Employed Individuals
Exclusion of Medicare Benefits
Deductibility of Medical Expenses
Earned Income Credit
Exclusion of Public Assistance and SSI Benefits
Dependent Care Tax Credit
HOPE Credit and Lifetime Learning Credit
Qualified Tuition Programs and Coverdell Education Savings
Accounts
Student Loan Interest Deduction
Qualified Tuition Deduction
Exclusion for Employer-Provided Dependent Care
Work Opportunity Tax Credit
Welfare-to-Work Tax Credit
Exclusion of Workers' Compensation and Special Benefits for Disabled
Coal Miners
Additional Standard Deduction for the Elderly and Blind
Tax Credit for the Elderly and Certain Disabled Individuals
Tax Provisions Related to Housing
Tax Credit and Exclusion for Adoption Expenses
Child Tax Credit
Effect of Tax Provisions on the Income and Taxes of the Elderly and
the Poor
References
INTRODUCTION
The preceding sections of this publication discuss direct
payments to individuals for retirement, health, public assistance,
employment, and disability benefits provided through entitlement
programs within the jurisdiction of the Committee on Ways and Means.
The Federal Government also provides benefits to individuals through
elements of the income tax set forth in the Internal Revenue Code of
1986 (the Code). The Code is entirely within the jurisdiction of the
Committee on Ways and Means.
TAX PROVISIONS
Several different types of income tax provisions are
available to provide economic incentives. Examples include:
exclusions, exemptions, deductions, preferential rates, deferrals
and credits. Measuring the amount of benefit afforded by a tax
provision is difficult. However, one way to measure the benefit
is to review the total estimated amounts excluded, exempted, or
otherwise afforded special treatment under various provisions of the
income tax.
USE OF DISTRIBUTIONAL ANALYSIS
Analyzing the effectiveness of tax provisions at achieving
their policy goals often involves examining the distribution of
benefits from the provisions allocated by the income class of those
who take advantage of the provisions. The income concept used to
show the distribution of tax expenditures by income class is adjusted
gross income (AGI) plus: (1) tax-exempt interest; (2) employer
contributions for health plans and life insurance; (3) employer share
of FICA taxes; (4) workers' compensation; (5) nontaxable Social
Security benefits; (6) insurance value of Medicare benefits;
(7) alternative minimum tax preferences; and (8) excluded income of
U.S. citizens living abroad.
This definition of income includes items that clearly increase
the ability to pay taxes, but that are not included in the definition
of AGI. However, it omits certain items that clearly affect ability
to consume goods and services either now or in the future, including
accrual of pension benefits, other fringe benefits (such as military
benefits, veterans benefits, and parsonage allowances), and means-
tested transfer payments (such as Aid to Families with Dependent
Children (AFDC), Supplemental Security Income, food stamps, housing
subsidies, and general assistance). The tax return is the unit of
analysis. Table 13-1 shows the distribution of all tax returns for
2003 by income class.
Unless specifically indicated, all distributional tables
exclude returns filed by dependents. All projections of income
and deduction items and tax parameters are based on economic
assumptions consistent with the December 2002 forecast of the
Congressional Budget Office.
TABLE 13-1 -- DISTRIBUTION BY INCOME CLASS OF ALL RETURNS, TAXABLE
RETURNS, ITEMIZED RETURNS, AND INDIVIDUAL INCOME TAX LIABILITY FOR
TAXABLE YEAR 2003
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
TAX PROVISION ESTIMATES
Table 13-2 provides various estimates for 37 tax provisions
related to retirement, health, poverty, employment, disability, and
housing. These provisions are examined in detail in this chapter
including their legislative history, an explanation of current law,
and a brief assessment of their effects.
NET EXCLUSION OF PENSION CONTRIBUTIONS AND EARNINGS
LEGISLATIVE HISTORY
Prior to 1921, no special tax treatment applied to employee
retirement trusts. Retirement payments to employees and contributions
to pension trusts were deductible by the employer as an ordinary and
necessary business expense. Employees were taxed on amounts actually
received as well as on employer contributions to a trust if there was
a reasonable expectation of benefits accruing from the trust. The
1921 Code provided an exemption for a trust forming part of a
qualified profit sharing or stock bonus plan.
The rules relating to qualified plans were substantially
revised by the Employee Retirement Income Security Act of 1974
(ERISA), which added overall limitations on contributions and
benefits and other requirements on
TABLE 13-2 -- ESTIMATED TAX BASE EXCEPTIONS AND CREDITS UNDER THE
PRESENT INCOME TAX FOR VARIOUS ITEMS,1 CALENDAR YEARS 2003-2007
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
minimum participation, coverage, vesting, benefit accrual, and
funding. Many revisions of these rules have been made since 1974.
Since ERISA, Congress has also acted to broaden the range of
qualified plans. In the Revenue Act of 1978, Congress provided
special rules for qualified cash or deferred arrangements under
section 401(k). Under these arrangements, known popularly as 401(k)
plans, employees can elect to receive cash or have their employers
contribute a portion of their earnings to a qualified profit sharing,
stock bonus, or pre-ERISA money purchase pension plan.
An employee stock ownership plan is a special type of
qualified plan that is designed to invest primarily in securities
of the employer maintaining the plan. Certain qualification rules
and tax benefits apply to employee stock ownership plans that do
not apply to other types of qualified plans.
EXPLANATION OF PROVISION
In General
Under a plan of deferred compensation that meets the
qualification standards of the Internal Revenue Code (sec.
401(a)), an employer is allowed a deduction for contributions
to a tax-exempt trust to provide employee benefits. Similar
rules apply to plans funded with annuity contracts. An employer
that makes contributions to a qualified plan in excess of the
deduction limits generally is subject to a 10-percent excise
tax on such excess (sec. 4972).
The qualification rules limit the amount of benefits that
can be provided through a qualified plan and require that benefits
be provided on a basis that does not discriminate in favor of highly
compensated employees. In addition, qualified plans are required to
meet minimum standards relating to participation (the restrictions
that may be imposed on participation in the plan), coverage (the
number of employees participating in the plan), vesting (the time at
which an employee's benefit becomes nonforfeitable), and benefit
accrual (the rate at which an employee earns a benefit). Also,
minimum funding standards apply to the rate at which employer
contributions are required to be made to defined benefit plans to
ensure the solvency of such plans.
If a defined benefit pension plan is terminated, any assets
remaining after satisfaction of the plan's liabilities may revert
to the employer. Such reversions are included in the gross income of
the employer and are subject to income tax plus an additional excise
tax (sec. 4980). The excise tax is 20 percent if the employer
establishes a qualified replacement plan or provides certain benefit
increases. Otherwise, the excise tax is 50 percent. Transfers of
excess assets can be made from an ongoing defined benefit plan to
pay certain retiree health benefits if certain requirements are
satisfied (sec. 420). The assets transferred are not includible in
the income of the employer or subject to the tax on reversions.
Minimum Participation Rules
A qualified plan generally may not require as a condition
of participation that an employee complete more than 1 year of
service or be older than age 21 (sec. 410(a)).
Vesting Rules
In general a plan is not a qualified plan unless a
participant's employer-provided benefit vests at least as rapidly
as under one of two alternative minimum vesting schedules (sec. 411).
More rapid vesting applies to employer matching contributions. In
addition, elective contributions to a section 401(k) plan and after-
tax employee contributions must be fully vested at all times.
Benefit Accrual Rules
The protection afforded employees under the minimum vesting
rules depends not only on the minimum vesting schedules, but also on
the accrued benefits to which these schedules are applied. In the
case of a defined contribution plan, the accrued benefit is the
participant's account balance. In the case of a defined benefit
plan, a participant's accrued benefit is determined under the plan
benefit formula, subject to certain restrictions. In general, the
accrued benefit is defined in terms of the benefit payable at
normal retirement age and does not include certain ancillary
nonretirement benefits.
Each defined benefit plan is required to satisfy one of
three accrued benefit tests. The primary purpose of these tests is
to prevent undue backloading of benefit accruals (i.e., by providing
low rates of benefit accrual in the employee's early years of
service when the employee is most likely to leave and by
concentrating the accrual of benefits in the employee's later years
of service when the employee is most likely to remain with the
employer until retirement) (sec. 412).
Coverage Rules
A plan is not qualified unless the plan satisfies at least
one of the following coverage requirements: (1) the plan benefits
at least 70 percent of all nonhighly compensated employees, (2)
the plan benefits a percentage of nonhighly compensated employees
that is at least 70 percent of the percentage of highly compensated
employees benefiting under the plan, or (3) the plan meets an
average benefits test (sec. 410(b)). In addition, a defined benefit
plan is not a qualified plan unless it benefits at least the lesser
of: (1) 50 employees, or (2) the greater of 40 percent of the
mployees of the employer or two employees (or if there is only one
employee, such employee) (sec. 401(a)(26)).
General Nondiscrimination Rule
In general, a plan is not a qualified plan if the
contributions or benefits under the plan discriminate in favor of
highly compensated employees (sec. 401(a)(4)).
Limitations on Contributions and Benefits
The maximum annual benefit that may be provided
by a defined benefit pension plan (payable at age 65) is the lesser
of 100 percent of average compensation, or $160,000 for 2003
(sec. 415(b)). The dollar limit is adjusted annually for inflation.
The dollar limit is reduced if payments of benefits begin before
age 62 and increased if benefits begin after age 65. The maximum
contributions that may be made to a defined contribution plan with
respect to a participant is the lesser of 100 percent of the
participant's compensation, or $40,000 for 2003 (sec.415(c)).
The dollar limit is adjusted annually for inflation.
Funding Rules
Pension plans are required to meet a minimum funding standard
for each plan year (sec. 412). In the case of a defined benefit
pension plan, an employer must contribute an annual amount sufficient
to fund a portion of participants' projected benefits determined in
accordance with one of several prescribed funding methods, using
reasonable actuarial assumptions. Certain plans with asset values of
less than 100 percent of current liabilities are subject to
additional, faster funding rules.
Taxation of Distributions
An employee who participates in a qualified plan is taxed when
the employee receives a distribution from the plan to the extent the
distribution is not attributable to after-tax employee contributions
(sec. 402). With certain exceptions, a 10-percent additional income
tax is imposed on early distributions from a qualified plan
(sec. 72(t)).
Failure to Satisfy Qualification Requirements
If a plan fails to satisfy the qualification requirements, the
trust that holds the plan's assets is not tax exempt. An employer's
deduction for plan contributions is only allowed when the employee
includes the contributions or benefits in income, and benefits
generally are includable in an employee's income when they are no
longer subject to a substantial risk of forfeiture.
SIMPLE Retirement Plans
The Small Business Job Protection Act of 1996 created a
simplified retirement plan for small business called the Savings
Incentive Match Plan for Employees (SIMPLE) (secs. 408(p) and
401(k)(11)). SIMPLE plans may be adopted by employers with 100 or
fewer employees and who do not maintain another employer-sponsored
retirement plan. A SIMPLE plan can be either an individual retirement
arrangement (IRA) for each employee or part of a qualified cash or
deferred arrangement (401(k) plan). If established in IRA form, a
SIMPLE plan is not subject to the nondiscrimination rules generally
applicable to qualified plans and simplified reporting requirements
apply. If adopted as part of a 401(k) plan, the plan does not have
to satisfy the special nondiscrimination tests applicable to 401(k)
plans and is not subject to the top-heavy rules. The other qualified
plan rules continue to apply. SIMPLE plans are subject to special
rules regarding eligibility of employees to participate and special
contribution limits.
Other Employer-Sponsored Retirement Arrangements
Certain other types of employer-sponsored retirement plans
provide tax benefits similar to those provided under qualified
retirement plans, including tax-sheltered annuities (sec. 403(b)
annuities), eligible deferred compensation plans of State and local
governmental employers (governmental sec. 457 plans), and simplified
employee pensions, referred to as "SEPs" (sec. 408(k)). Each of
these arrangements is subject to different requirements, including
contribution limits. These arrangements are not subject to many of
the requirements applicable to qualified plans.
Saver's Credit
The Economic Growth and Tax Relief Reconciliation Act,
"EGTRRA," provides a temporary nonrefundable tax credit for eligible
taxpayers for qualified retirement saving contributions, effective
for taxable years beginning after December 31, 2001, and before
January 1, 2007. The credit is available with respect to (1) elective
deferrals to 401(k) loans, tax-sheltered annuities, governmental 457
plans, SIMPLE retirement plans, or SEPs; (2) contributions to a
traditional or Roth IRA; and (3) voluntary after-tax employee
contributions to a tax sheltered annuity or qualified retirement plan.
The amount of any contribution eligible for the credit is reduced by
certain distributions received from these arrangements.
The maximum annual contribution eligible for the credit is
$2,000. The credit rate varies from 10 percent to 50 percent,
depending on the adjusted gross income (AGI) of the taxpayer. Taxpayers
filing joint returns with AGI of $50,000 or less, head of household
returns of $37,500 or less, and single returns of $25,000 or less are
eligible for the credit. The AGI limits applicable to single taxpayers
apply to married taxpayers filing separate tax returns. The credit is
in addition to any deduction or exclusion that would otherwise apply
with respect to the contribution. The credit offsets minimum tax
liability as well as regular tax liability. The credit is available
to individuals who are 18 or over, other than individuals who are
full-time students or claimed as a dependent on another taxpayer's
return.
EFFECT OF PROVISION
The tax treatment of pension contributions and earnings has
encouraged employers to establish qualified retirement plans and to
compensate employees in the form of pension contributions to such
plans. There are two potential tax advantages of being compensated
through pension contributions. One advantage is the ability to earn
tax-free returns to savings. When saving is done through a pension
plan, the employee earns a higher rate of return than on fully taxed
savings. The second advantage is that an employee's tax rate may be
lower during retirement than during the working years.
These tax provisions directly benefit only persons who work
for employers with qualified plans and who work for a sufficient
period of time before their benefits vest in such plans. The current
extent of this coverage and recent trends in coverage are described
below.
COVERAGE
The term "covered," as used here, means that an employee is
accruing benefits in an employer pension or other retirement plan. The
most recent data regarding pension coverage is the March 2003 Current
Population Survey. The data referred to below come from that survey
unless otherwise noted.
As of March 2003, 57 percent of the nonelderly full-time wage
and salary workers employed in the private sector reported that they
worked in firms with an employer-sponsored pension plan in 2002
(Table 13-3). Slightly less than half (46 percent) of the full-time
wage and salary workers employed in the private sector were covered
by an employer-sponsored pension plan.
Pension coverage varies substantially among full-time,
privately employed workers. Differences depend on the age of the
worker, job earnings, the industry of employment, and the size of the
firm.
Younger workers are much less likely to be covered by a
pension than middle aged and older workers. Coverage rates rise
steadily from 19 percent for those under age 25 to about 60 percent
for those between ages 40 and 60 before falling off substantially for
those over age 65. This pattern holds for both men and women. However,
the jump in coverage for middle aged men is slightly larger than the
increase for middle aged women (Table 13-4).
Higher paying jobs are more likely to offer pensions. Just
10 percent of full-time private wage and salary workers earning less
than $10,000 per year in 2002 were covered compared to 68 percent or
more of those earning $50,000 or more (Table 13-5). Coverage may be
higher for higher paying jobs because of the greater value of the
pension tax benefits to workers in higher tax brackets and because of
the declining replacement rate of Social Security at higher earnings
levels.
TABLE 13-3 -- EMPLOYER SPONSORSHIP AND EMPLOYEE PARTICIPATION IN
RETIREMENT PLANS, 2002
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
TABLE 13-4 -- PARTICIPATION IN EMPLOYER-SPONSORED RETIREMENT PLANS
AMONG PRIVATE-SECTOR WAGE AND SALARY WORKERS EMPLOYED FULL-
TIME IN 2002, BY WORKERS' AGE
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
TABLE 13-5 -- PARTICIPATION IN EMPLOYER-SPONSORED RETIREMENT PLANS
AMONG PRIVATE-SECTOR WAGE AND SALARY WORKERS EMPLOYED FULL TIME
IN 2002, BY WORKER'S EARNINGS
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
Coverage is much lower for smaller firms. Smaller firms are
less likely to offer comprehensive fringe benefit packages as part of
total compensation. Only 19 percent of full-time private wage and
salary workers in firms with fewer than 10 employees are covered. The
rate rises with employer size but does not reach 46 percent (the
average across all firm sizes) until firms have 100 or more employees
(Table 13-6).
Significant differences in coverage also are apparent between
full-time private wage and salary workers and other wage and salary
workers. Coverage is much lower among part-time workers and much
higher among public employees. Among part-time, private wage and
salary workers, 13 percent are covered. Seventy-two percent of public
sector wage and salary workers are covered including 80 percent of
those who are full-time workers (Table 13-7).
TABLE 13-6 -- PARTICIPATION IN EMPLOYER-SPONSORED RETIREMENT PLANS
AMONG PRIVATE-SECTOR WAGE AND SALARY WORKERS EMPLOYED FULL TIME
IN 2002, BY SIZE OF FIRM
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
TRENDS IN COVERAGE
At the outset of World War II, private employer pensions were
offered by about 12,000 firms. Pensions spread rapidly during and
after the war, encouraged by high marginal tax rates and wartime wage
controls that exempted pension benefits. By 1972, when the first
comprehensive survey was undertaken, 48 percent of full-time private
employees were covered. Subsequent surveys in 1979, 1983, 1988, and
1993 showed that coverage remained fairly constant, never falling below
46 percent or rising above 50 percent. However, the survey in 1998
showed a drop in coverage to 43 percent. The most recent survey in
2003 showed coverage at 46 percent (Table 13-3).
For workers with pension coverage, there has been a shift
away from defined benefit plans. Of the private wage and salary
workers covered by a pension plan in 1975, 87 percent were covered by
a defined benefit plan (Turner & Beller, 1989, pp. 65 & 357). This
proportion dropped to 83 percent by 1980 and to 71 percent by 1985.
This proportion dropped even lower to 65 percent in 1993 (Department
of Labor, 1994, tables A2, B1, B2). This shifting composition has
largely been the result of rapid growth in primary defined
contribution plans. Employee stock ownership plans and 401(k) plans
have been among the most rapidly growing defined contribution plans.
TABLE 13-7 -- PARTICIPATION IN EMPLOYER-SPONSORED RETIREMENT PLANS
AMONG ALL WAGE AND SALARY WORKERS IN 2002, BY SECTOR OF EMPLOYMENT
[GRAPHICS NOT AVAIABLE IN TIFF FORMAT]
INDIVIDUAL RETIREMENT ARRANGEMENTS "IRAS"
LEGISLATIVE HISTORY
ERISA added section 219 to the Internal Revenue Code,
providing a tax deduction for certain contributions to IRAs and
permitting the deferral of tax on amounts held in such arrangements
until withdrawal. Active participants in employer plans were not
permitted to make deductible IRA contributions.
The Economic Recovery Tax Act of 1981 expanded eligibility
to individuals who were active participants and increased the amount
of the permitted deduction. The Tax Reform Act of 1986 limited the
full IRA deduction to individuals with income below certain levels
and to individuals who are not active participants in employer plans.
Individuals who are not entitled to the full IRA deduction may
make nondeductible contributions to an IRA. The Small Business Job
Protection Act of 1996 increased contributions that can be made to
the IRA of a nonworking spouse. The Health Insurance Portability and
Accountability Act provided that the early withdrawal tax does not
apply to withdrawals from IRAs: (1) for medical expenses that would
be deductible (i.e., to the extent that total medical expenses exceed
7.5 percent of AGI); and (2) for health insurance expenses of
unemployed individuals.
The Taxpayer Relief Act of 1997, effective for years
beginning after December 31, 1997, made the following changes to the
IRA provisions: (1) the income limits on deductible IRA contributions
that apply to active participants in an employer-sponsored retirement
plan were increased; (2) the nonworking spouse of an active
participant in an employer-sponsored retirement plan may make a
deductible contribution of up to $2,000 to an IRA; (3) a new tax-free
nondeductible IRA, the Roth IRA, was added; and (4) the 10-percent
early withdrawal tax was waived for distributions from IRAs for
education and first-time home buyer expenses.
The annual limit on aggregate IRA contributions was increased
again by The Economic Growth and Tax Relief Reconciliation Act of 2001
("EGTRRA"). EGTRRA also allows individuals who have attained age 50
to make additional catch-up contributions to an IRA.
EXPLANATION OF PROVISION
Traditional IRAs
An individual who is an active participant in an employer-
sponsored retirement plan may deduct annual IRA contributions up to
the lesser of $3,000 (for 2003) or 100 percent of compensation if the
individual's adjusted gross income (AGI) does not exceed certain
limits.
The maximum deduction for IRA contributions for an individual
who has attained age 50 before the end of the year is increased by a
certain dollar amount ($500 for 2003). (The maximum dollar limit on
IRA contributions applies to aggregate IRA contributions of an
individual, including contributions to a Roth IRA.)
If an individual (or the individual's spouse) is an active
participant in an employer-sponsored retirement plan, the deduction is
phased out for taxpayers with adjusted gross income over certain
levels for the taxable year. The adjusted gross income phase-out
limits for taxpayers who are active participants in employer-sponsored
plans are as follows:
Single Taxpayers
Taxable years beginning in: Phase-out range
2003 40,000-50,000 40,000-50,000
2004 45,000-55,000 45,000-55,000
2005 and thereafter 50,000-60,000
Joint Returns
Taxable years beginning in: Phase-out range
2003 60,000-70,000
2004 65,000-75,000
2005 70,000-80,000
2006 75,000-85,000
2007 and thereafter 80,000-100,000
The adjusted gross income phase-out range for married
taxpayers filing a separate return is $0 to $10,000.
An individual who is not an active participant, but whose
spouse is, may make a full deductible IRA contribution if the AGI for
the couple does not exceed $150,000. The deduction limit in such
cases is phased out for AGI between $150,000 and $160,000. An
individual who is not an active participant in an employer-sponsored
retirement plan may deduct IRA contributions up to the limits
described above without limitation based on income.
The investment income of IRA accounts is not taxed until
withdrawn. Withdrawn amounts attributable to deductible contributions
and all earnings are includible in income. A 10-percent additional
income tax applies unless the withdrawal: (1) is made after the IRA
owner attains age 59� or dies; (2) is made on account of the
disability of the IRA owner; (3) is one of a series of substantially
equal periodic payments made not less frequently than annually over
the life or life expectancy of the IRA owner (or the IRA owner and
his or her beneficiary); (4) is made to pay medical expenses in
excess of 7.5 percent of AGI or for health insurance premiums for
unemployed individuals; or (5) is made for first-time home buyer
expenses (subject to a $10,000 lifetime cap) or for qualified
higher education expenses.
Nondeductible IRAs
An individual may make nondeductible contributions to a
traditional IRA to the extent the individual does not or cannot make
deductible contributions to an IRA or contributions to a Roth IRA.
Earnings on contributions to a nondeductible IRA accumulate tax free,
and are includible in income when withdrawn. The 10-percent early
withdrawal tax applies to such earnings, subject to the exceptions
for IRAs as described above.
Roth IRAs
Individuals with adjusted gross income below certain levels
may make nondeductible contributions to a Roth IRA. The maximum
annual contribution that may be made to a Roth IRA is the lesser of
a certain dollar amount ($3,000 for 2003) or the individual's
compensation for the year. An individual who has attained age 50
before the end of the taxable year also may make catch-up
contributions to a Roth IRA up to a certain dollar amount ($500 for
2003). The contribution limit is reduced to the extent an individual
makes contributions to any other IRA for the same taxable year. The
maximum annual contribution that can be made to a Roth IRA is phased
out for single individuals with adjusted gross income between $95,000
and $110,000 and for joint filers with adjusted gross income between
$150,000 and $160,000. The adjusted gross income phase-out range for
married taxpayers filing a separate return is $0 to $10,000.
Qualified distributions from a Roth IRA are not includable in
income. Qualified distributions are distributions: (1) made after the
5-year taxable period beginning with the first taxable year for which
a contribution is made, and (2) which are made on or after the date
the individual attains age 59�, are made to a beneficiary on or after
the death of the individual, are attributable to the individual's
being disabled, or are for a qualified special purpose distribution.
A qualified special purpose distribution is a distribution for
first-time home buyer expenses, as described above. Distributions
that are not qualified distributions are includible in income, to
the extent earnings are included in the distribution, and are
subject to the 10-percent tax on early withdrawal, unless an
exception applies, as described above for traditional IRAs.
Taxpayers with AGI of less than $100,000 may convert an IRA
to a Roth IRA at any time. If the conversion was made before
January 1, 1999, the amounts that would have been includible in
income had the amounts converted been withdrawn are includible in
income ratably over four years. The 10-percent tax on early
withdrawals does not apply to conversions of IRAs to Roth IRAs.
EFFECT OF PROVISION
Use of IRAs expanded significantly when eligibility was
expanded in 1982 to all persons with earnings and contracted
correspondingly in 1987 when deductibility was restricted for higher
income taxpayers who were covered by an employer-provided pension.
The number of taxpayers claiming a deductible IRA contribution jumped
from 3.4 million in 1981 to 12.0 million in 1982 and peaked at 16.2
million in 1985. In 1987, only 7.3 million taxpayers reported
deductible contributions. Since then, the number generally has
continued to fall (Table 13-8).
Upper-income taxpayers facing higher marginal tax rates
receive more benefit per dollar of IRA deduction than do low-income
taxpayers facing lower marginal tax rates. When IRAs were available to
all workers, the percentage of taxpayers contributing to an IRA was
substantially higher among taxpayers with higher income. For example,
in 1985, 13.6 percent of taxpayers with AGI between $10,000 and
$30,000 contributed to an IRA compared with 74.1 percent of taxpayers
with AGI between $75,000 and $100,000.
The decline in IRA use between 1985 and 1990 among those with
AGI between $10,000 and $30,000 appears to be larger than the
reduction required by the change in law since the restrictions on
deductible contributions apply only to a small fraction of taxpayers
with AGI below $30,000.
Before EGTRRA, eligibility percentages and the real value of
the IRA contribution limits declined over time because prior law did
not index the contribution limits or the income eligibility limits for
inflation. For example, the real value of a $2,000 contribution
declined more than 38 percent between 1986 and 2001 because of
inflation. Under EGTRRA, the IRA contribution limit increases to
$5,000 in 2008 and is indexed for inflation (subject to the general
EGTRRA sunset for years beginning after December 31, 2010).
Congress established IRAs to allow workers not covered by
employer pension plans to have tax-advantaged retirement saving.
Nonetheless, since 1981 IRA participation rates have been higher
among those covered by an employer-provided pension plan than those
without one, and many of those who are not covered by a pension plan
do not contribute to an IRA. In 1987, 10 percent of full-time
private-sector earners without pension coverage contributed
to an IRA, while 15 percent of those with coverage contributed
(Woods, 1989, p. 9).
TABLE 13-8 -- USE OF DEDUCTIBLE IRAs, 1980-2000
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
EXCLUSION OF SOCIAL SECURITY AND RAILROAD RETIREMENT BENEFITS
LEGISLATIVE HISTORY
The exclusion from gross income for Social Security benefits
was not initially established by statute. Prior to the Social Security
Amendments of 1983, the exclusion was based on a series of
administrative rulings issued by the Internal Revenue Service in 1938
and 1941.
Under the Social Security Amendments of 1983, a portion of
the Social Security benefits paid to higher income taxpayers is
included in gross income. In 1993, the Omnibus Budget Reconciliation
Act increased the amount of benefits subject to tax and increased the
rate of tax for some benefit recipients.
The exclusion from gross income of benefits paid under the
Railroad Retirement System was enacted in the Railroad Retirement Act
of 1935. A portion of the benefits payable under the Railroad
Retirement System (generally, tier 1 benefits) is equivalent to Social
Security benefits. The tax treatment of tier 1 railroad retirement
benefits was modified in the Social Security Amendments of 1983 to
conform to the tax treatment of Social Security benefits. Other
railroad retirement benefits are taxable in the same manner as
employer-provided retirement benefits. The Consolidated Omnibus Budget
Reconciliation Act of 1985 provided that tier 1 benefits are taxable
in the same manner as Social Security benefits only to the extent that
Social Security benefits otherwise would be payable. Other tier 1
benefits are taxable in the same manner as all other railroad
retirement benefits (for further details, see section 5).
EXPLANATION OF PROVISION
For taxpayers whose modified AGI exceeds certain limits, a
portion of Social Security and tier 1 railroad retirement benefits is
included in taxable income. Modified AGI is AGI plus interest on tax-
exempt bonds plus 50 percent of Social Security and tier 1 railroad
retirement benefits. A two-tier structure applies. The base tier is
$25,000 for unmarried individuals and $32,000 for married couples
filing joint returns, and zero for married persons filing separate
returns who do not live apart at all times during the taxable year.
The amount of benefits includable in income is the lesser of
50 percent of the Social Security and tier 1 railroad retirement
benefits or 50 percent of the excess of the taxpayer's combined income
over the base amount.
The second tier applies to taxpayers with modified AGI of at
least $34,000 (unmarried taxpayers) or $44,000 (married taxpayers
filing joint returns). For these taxpayers, the amount of benefits
includable in gross income is the lesser of 85 percent of Social
Security benefits or the sum of 85 percent of the amount by which
modified AGI exceeds the second-tier thresholds, and the smaller of
the amount included under prior law or $4,500 (unmarried taxpayers)
or $6,000 (married taxpayers filing jointly). The portion of tier 1
railroad retirement benefits potentially includable in taxable income
under the above formula is the amount of benefits the taxpayer would
have received if covered under Social Security. Pursuant to section
72(r) of the Internal Revenue Code, all other benefits payable under
the Railroad Retirement System are includable in income when received
to the extent they exceed employee contributions.
EFFECT OF PROVISION
Approximately one-third of all Social Security recipients pay
taxes on their benefits. This percentage is likely to increase over
time because the thresholds are not adjusted annually for past
inflation or other factors.
EXCLUSION OF EMPLOYER CONTRIBUTIONS FOR MEDICAL INSURANCE PREMIUMS
AND MEDICAL CARE
LEGISLATIVE HISTORY
In 1943, the Internal Revenue Service (IRS) ruled that
employer contributions to group health insurance policies were not
taxable to the employee. Employer contributions to individual health
insurance policies, however, were declared to be taxable income in
an IRS revenue ruling in 1953.
Section 106 of the Internal Revenue Code, enacted in 1954,
reversed the 1953 IRS ruling. As a result, employer contributions to
all accident or health plans generally are excluded from gross income
and therefore are not subject to tax. Under section 105 of the
Internal Revenue Code, benefits received under an employer's accident
or health plan generally are not included in the employee's income.
In the Revenue Act of 1978, Congress added section 105(h) to
tax the benefits payable to highly compensated employees under a
self-insured medical reimbursement plan if the plan discriminated in
favor of highly compensated employees.
EXPLANATION OF PROVISION
Gross income of an employee generally excludes employer-
provided coverage under an accident or health plan. The exclusion
applies to coverage provided to former employees, their spouses, or
dependents. Amounts excluded include those received by an employee
for personal injuries or sickness if the amounts are paid directly
or indirectly to reimburse the employee for expenses incurred for
medical care. However, this exclusion does not apply in the case of
amounts paid to a highly compensated individual under a self-insured
medical reimbursement plan if the plan violates the nondiscrimination
rules of section 105(h).
Present law permits employers to prefund medical benefits for
retirees. Postretirement medical benefits may be prefunded by the
employer in two basic ways: (1) through a separate account in a
tax-qualified pension plan (sec. 401(h)); or (2) through a welfare
benefit fund (secs. 419 and 419A). Generally, the amounts contributed
are excluded from the income of the plan or participants. Although
amounts held in a section 401(h) account are accorded tax-favored
treatment similar to assets held in a pension trust, the benefits
provided under a section 401(h) account are required to be incidental
to the retirement benefits provided by the plan. Amounts contributed
to welfare benefit funds are subject to certain deduction limitations
(secs. 419 and 419A). In addition, the fund is subject to income tax
relating to any set-aside to provide postretirement medical benefits.
EFFECT OF PROVISION
The exclusion for employer-provided health coverage provides
an incentive for compensation to be furnished to the employee in the
form of health coverage, rather than in cash subject to current
taxation. For example, an employer designing a compensation package
for an employee would be indifferent between paying the employee one
dollar in cash and purchasing one dollar's worth of health insurance
for the employee. 3 On the other hand, because the employee is likely
to pay Federal and State income taxes and payroll taxes on cash
compensation and no tax on health insurance contributions made on his
behalf, the employee would likely prefer that some compensation be in
the form of health insurance. Employees subject to tax at the highest
marginal tax rates have the greatest incentive to receive compensation
in nontaxable forms.
The tax preference that the exclusion provides is substantial
and has resulted in widespread access to health coverage. A majority
of the population now receives health insurance as a consequence of
their own employment or of a family member's employment. According to
a special analysis of data from the Current Population Survey
conducted by the Congressional Budget Office, nearly 75 percent of
all workers under age 65 were covered by employment-based health
insurance. Slightly over 4 percent of the workers under age 65
purchased insurance privately and nearly 3 percent received public
insurance either through Medicare, Medicaid, or the Department of
Veterans Affairs. The analysis reveals that slightly more than 18
percent of the workers under age 65 had no health insurance, up from
15 percent in 1996 (Committee, 1998, pp. 853-54).
Health coverage through employer-based plans tends to be
more prevalent in the finance, government, manufacturing, mining,
professional service, transportation, and wholesale trade sectors
of the economy; among medium and large firms; for more highly paid
workers; and among those over age 30 (Table 13-9).
TAX CREDIT FOR HEALTH INSURANCE OF ELIGIBLE
INDIVIDUALS
The Trade Act of 2002 created a refundable tax credit equal
to 65 percent of an eligible taxpayer's expenses for qualified health
insurance of the taxpayer and qualifying family members for certain
periods. Eligible individuals include eligible TAA recipients,
eligible alternative TAA recipients, and eligible PBGC pension
recipients. The credit is payable on an advanced basis.
MEDICAL SAVINGS ACCOUNTS
The Health Insurance Portability and Accountability Act of
1996 included provisions for medical savings accounts (MSAs),
effective for years beginning after December 31, 1996. MSAs were
renamed Archer MSAs by the Community Renewal Tax Relief Act of 2000
(P.L. 106-554). Within limits, contributions to an Archer MSA are
deductible if made by an eligible individual and are excludable from
income and employment taxes if made by the employer (other than
contributions made through a cafeteria plan). Earnings on amounts in
an Archer MSA are not currently taxable. Distributions from an Archer
MSA for medical expenses are not includible in gross income.
Distributions from an Archer MSA that are not for medical expenses
are includible in gross income and are subject to an additional tax
of 15 percent, unless the distribution is made after death,
disability, or age 65.
TABLE 13-9--PRIMARY SOURCE OF HEALTH INSURANCE FOR WORKERS UNDER
AGE 65, BY DEMOGRAPHIC CATEGORY, MARCH 2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
Archer MSAs are available to employees covered under an
employer-sponsored high deductible health plan of a small employer
and to self-employed individuals covered under a high deductible
health plan (regardless of the size of the entity for which the self-
employed individual performs services). A small employer is defined
as an employer with 50 or fewer employees.
In order to be eligible for an Archer MSA contribution, an
otherwise eligible individual must be covered under a high deductible
health plan and no other health plan. A high deductible health plan
is a plan with an annual deductible of at least $1,500 and no more
than $2,250 in the case of individual coverage (and at least $3,000
and no more than $4,500 in the case of family coverage). The
adjusted annual deductible amounts for tax years beginning in 2003
are between $1,700 and $2,500 for individual coverage and between
$3,350 and $5,050 for family coverage. The dollar limits are
indexed for inflation. High deductible plans must also meet certain
limits on out-of-pocket expenses.
The number of taxpayers benefiting annually from an Archer
MSA contribution is limited to a threshold level (generally, 750,000
taxpayers). If it is determined in a year that the threshold level
has been exceeded (called a cutoff year), then, in general, for
succeeding years during the pilot period 1997-2003, only those
individuals who (1) made an MSA contribution or had an employer
Archer MSA contribution for the year or a preceding year (i.e.,
are active Archer MSA participants) or (2) are employed by a
participating employer, would be eligible for an MSA contribution.
In determining whether the threshold for any year has been exceeded,
Archer MSAs of previously uninsured individuals are not taken into
account.
After December 31, 2003, no new contributions may be made
to Archer MSAs except by or on behalf of an individual who previously
had Archer MSA contributions and employees who are employed by a
participating employer. Self-employed individuals who made
contributions to an Archer MSA during the period 1997-2003 also may
continue to make contributions after 2003.
HEALTH SAVINGS ACCOUNTS
The Medicare Prescription Drug, Improvement, and
Modernization Act of 2003 (P.L. 108-173) added provisions for health
savings accounts (HSAs), effective for taxable years beginning after
December 31, 2003. Within limits, contributions to an HSA made by
or on behalf of an eligible individual are deductible by the
individual. Contributions to an HSA are excludable from income and
employment taxes if made by the employer. Earnings on amounts in
HSAs are not taxable. Distributions from an HSA for qualified medical
expenses are not includible in gross income. Distributions from an
HSA that are not used for qualified medical expenses are includible
in gross income and are subject to an additional tax of 10 percent,
unless the distribution is made after death, disability, or the
individual attains the age of Medicare eligibility (i.e., age 65).
Eligible individuals for HSAs are individuals who are covered
by a high deductible health plan and no other health plan that is not
a high deductible health plan. A high deductible health plan is a
health plan that has a deductible that is at least $1,000 for self-
only coverage or $2,000 for family coverage (indexed for inflation)
and that has an out-of-pocket expense limit that is no more than
5,000 in the case of self-only coverage and $10,000 in the case of
family coverage.
The maximum aggregate annual contribution that can be made to
an HSA is the lesser of (1) 100 percent of the annual deductible
under the high deductible health plan, or (2) the maximum deductible
permitted under an Archer MSA high deductible health plan under
present law, as adjusted for inflation. For 2004, the amount of the
maximum deductible under an Archer MSA high deductible health plan is
$2,600 in the case of self-only coverage and $5,150 in the case of
family coverage. The annual contribution limits are increased for
individuals who have attained age 55 by the end of the taxable year.
In the case of policyholders and covered spouses who are age 55 or
older, the HSA annual contribution limit is greater than the
otherwise applicable limit by $500 in 2004, $600 in 2005, $700 in
2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and thereafter.
CAFETERIA PLANS
LEGISLATIVE HISTORY
Under present law, compensation generally is includible in
gross income when received. An exception applies if an employee may
choose between cash and certain employer-provided nontaxable benefits
under a cafeteria plan.
Prior to 1978, ERISA provided that an employer contribution
made before January 1, 1977, to a cafeteria plan in existence on
June 27, 1974, had to be included in an employee's gross income only
to the extent that the employee actually elected taxable benefits. If
a plan did not exist on June 27, 1974, the employer contribution was
to be included in income to the extent the employee could have elected
taxable benefits. The Revenue Act of 1978 set up permanent rules for
plans that offer an election between taxable and nontaxable benefits.
The Deficit Reduction Act of 1984 (P.L. 98-369) clarified the
types of employer-provided benefits that could be provided through a
cafeteria plan, added a 25-percent concentration test, and required
annual reporting to the IRS by employers.
The Tax Reform Act of 1986 also modified the rules relating
to cafeteria plans in several respects.
EXPLANATION OF PROVISION
A participant in a cafeteria plan (sec. 125) is not treated
as having received taxable income solely because the participant had
the opportunity to elect to receive cash or certain nontaxable
benefits. In order to meet the requirements of section 125, the plan
must be in writing, must include only employees (including former
employees) as participants, and must satisfy certain nondiscrimination
requirements.
In general, a nontaxable benefit may be provided through a
cafeteria plan if the benefit is excludable from the participant's
gross income by reason of a specific provision of the Code. These
include employer-provided health coverage, group-term life insurance
coverage, and benefits under dependent care assistance programs. A
cafeteria plan may not provide qualified scholarships or tuition
reduction, educational assistance, miscellaneous employer-provided
fringe benefits, or deferred compensation except through a qualified
cash or deferred arrangement.
If the plan discriminates in favor of highly compensated
individuals regarding eligibility to participate, to make
contributions, or to receive benefits under the plan, then the
exclusion does not apply to such individuals. For purposes of these
nondiscrimination requirements, a highly compensated individual is an
officer, a shareholder owning more than 5 percent of the employing
firm, a highly compensated individual determined under the facts and
circumstances of the case, or a spouse or dependent of the above
individuals.
EFFECT OF PROVISION
The optimal compensation of employees (in a tax planning
sense) would require that employers and employees arrive at the
compensation package that provides the largest after-tax benefit
to the employee at minimum after-tax cost to the employer (see
Scholes & Wolfson, 1992, chapter 10). Both the potential taxation
of compensation provided to employees and the deductibility of
compensation provided by the employer would be considered. If only
income taxes were considered, employers would be indifferent between
the payment of $1 in salary or wages and the payment of $1 in fringe
benefits to an employee, because both types of compensation are
fully deductible. When the employer payments for FICA and Federal
Unemployment Tax Act (FUTA) taxes are considered, however, the
employer might actually find it less costly to compensate an
employee with a dollar's worth of fringe benefit not subject to FICA
and FUTA taxes rather than a dollar of wage or salary payments that
are subject to these taxes.
The employee, however, would prefer to be compensated in the
form that provides the highest after-tax value. An additional dollar
of salary or wage paid to the employee will be subject to tax. If a
fringe benefit is excludable from the employee's income, the employee
pays no tax on receipt of the benefit. Consequently, the employee
receives greater compensation via the fringe benefit. This
differential treatment of salary or wage payments and excludable
fringe benefits implies that compensation packages designed to
minimize the joint tax liability of employers and employees could
include substantial amounts of excludable fringe benefits.
Employees may have different preferences about the allocation
of their compensation. For example, an employee with no dependents may
place little value on employer provided life insurance. Cafeteria
plans permit employees some discretion as to the provided benefits,
and will tend to be preferred to benefit plans in which all employees
of the firm receive the identical benefit package.
Cafeteria plans are a growing part of compensation plans,
particularly for larger employers. The Bureau of Labor Statistics
estimated that in 1997, 52 percent of employees at large- and medium-
sized firms were eligible for some type of cafeteria plan. This
figure has grown from an estimated 5 percent in 1986 (U.S. Bureau of
Labor Statistics, 1993). Smaller firms generally do not offer
cafeteria plans to their workers. For example, in 1996, only
23 percent of the workers in small, private establishments (nonfarm
establishments with fewer than 100 employees) were eligible to
participate in a cafeteria plan (U.S. Bureau of Labor Statistics,
1996). The lower figure for smaller firms reflects in part the
less generous fringe benefit packages provided by smaller firms.
Like any income exclusion, the exclusion from gross income
for cafeteria plan benefits can lead to disparities in the tax
system. Employees with the same total compensation can have taxable
incomes that are substantially different because of the form in which
compensation is received. The exclusion for cafeteria plan benefits
also may be used in some cases to avoid the 7.5 percent of AGI floor
on deductible medical expenses. The use of cafeteria plans reduces
the aftertax cost of health care to employees using these plans, which
could cause these employees to purchase a larger amount of health
care services. On the other hand, cafeteria plans could encourage
employers to increase the share of premiums, copayments, and
deductibles paid by employees, resulting in increased employee
awareness of the costs of their health plans. This incentive could
result in reduced health care costs.
HEALTH CARE CONTINUATION RULES
LEGISLATIVE HISTORY
The Consolidated Omnibus Budget Reconciliation Act of 1985
added sections 106(b), 162(i)(2), and 162(k) to the Internal Revenue
Code under which certain group health plans are required to offer
health coverage to certain employees and former employees, as well
as to their spouses and dependents. Parallel requirements were added
to title I of ERISA and the Public Health Services Act. If an
employer failed to satisfy the health care continuation rules, the
employer was denied a deduction for contributions to its group health
plans and highly compensated employees were required to include in
taxable income the employer-provided value of the coverage received
under such plans.
The Technical and Miscellaneous Revenue Act of 1988 made
several changes to the health care continuation rules. Sections
106(b), 162(i)(2), and 162(k) were repealed and replaced by section
4980B. Section 4980B imposes an excise tax on the employer or other
responsible party who fails to satisfy the rules instead of denying
deductions and the exclusion. The Health Insurance Portability and
Accountability Act of 1996 made some changes to the health care
continuation rules in cases of disability.
EXPLANATION OF PROVISION
The health care continuation rules in section 4980B require
that an employer provide qualified beneficiaries with the opportunity
to participate for a specified period in the employer's health plan
after that participation otherwise would have terminated. If the
employee elects such continuation coverage, the employee may be
required to pay for the coverage. The amount the employee can be
required to pay is subject to certain limits.
The qualifying events that may trigger rights to continuation
coverage are: (1) the death of the employee; (2) the voluntary or
involuntary termination of the employee's employment (other than by
reason of gross misconduct); (3) a reduction of the employee's hours;
(4) the divorce or legal separation of the employee; (5) the employee
becoming entitled to benefits under Medicare; and (6) a dependent
child of the employee ceasing to be a dependent under the employer's
plan. The maximum period of continuation coverage is 36 months,
except in the case of termination of employment or reduction of hours
for which the maximum period is 18 months. The 18-month period is
extended to 29 months in certain cases involving the disability of
the qualified beneficiary. Certain events, such as the failure by the
qualified beneficiary to pay the required premium, may trigger an
earlier cessation of the continuation coverage.
A beneficiary has a prescribed period of time during which to
elect continuation coverage after the employee receives notice from
the plan administrator of the right to continuation coverage.
GROUP HEALTH PLAN REQUIREMENTS
The Health Insurance Portability and Accountability Act of
1996 imposes certain requirements regarding health coverage
portability through limitations on preexisting condition exclusions,
prohibitions on excluding individuals from coverage based on health
status, and guaranteed renewability of health insurance coverage. An
excise tax is imposed with respect to failures of a group health
plan to comply with the requirements. The tax is usually imposed on
the employer sponsoring the plan. The amount of the tax is generally
equal to $100 per day for each day during which the failure occurs
until the failure is corrected. The maximum tax that can be imposed
is the lesser of 10 percent of the employer's payments during the
taxable year in which the failure occurred under group health plans
or $500,000. The Secretary of the Treasury may waive all or part of
the tax to the extent that payment of the tax would be excessive
relative to the failure involved (see discussion of health care
continuation rules).
TAX BENEFITS FOR ACCELERATED DEATH BENEFITS AND LONG-TERM CARE
INSURANCE
LEGISLATIVE HISTORY
Accelerated Death Benefits
If a contract meets the definition of a life insurance
contract, gross income does not include insurance proceeds that are
paid pursuant to the contract by reason of the death of the insured
(sec. 101(a)). In addition, the undistributed investment income
(inside buildup) earned on premiums credited under the contract is
not subject to current taxation to the owner of the contract. The
exclusion under section 101 applies regardless of whether the
death benefits are paid as a lump sum or otherwise.
If a contract fails to be treated as a life insurance
contract under section 7702(a), inside buildup on the contract is
generally subject to tax (sec. 7702(g)).
To qualify as a life insurance contract for Federal income
tax purposes, a contract must be a life insurance contract under
the applicable State or foreign law and must satisfy either of two
alternative tests: (1) a cash value accumulation test, or (2) a
test consisting of a guideline premium requirement and a cash value
corridor requirement (sec. 7702(a)). A contract satisfies the cash
value accumulation test if the cash surrender value of the contract
may not at any time exceed the net single premium that would have
to be paid at such time to fund future benefits under the contract.
A contract satisfies the guideline premium and cash value corridor
tests if the premiums paid under the contract do not at any time
exceed the greater of the guideline single premium or the sum of the
guideline level premiums, and if the death benefit under the
contract is not less than a varying statutory percentage of the cash
surrender value of the contract.
Long-Term Care Insurance
Prior to the Health Insurance Portability and Accountability
Act of 1996, tax law generally did not provide explicit rules
relating to the tax treatment of long-term care insurance contracts
or long-term care services. Thus, the treatment of long-term care
contracts and services was unclear. Prior and present law provide
rules relating to medical expenses and accident or health insurance.
Amounts received by a taxpayer under accident or health insurance for
personal injuries or sickness generally are excluded from gross
income to the extent that the amounts received are not attributable
to medical expenses that were allowed as a deduction for a prior
taxable year (sec. 104).
EXPLANATION OF PROVISION
Accelerated Death Benefits
The Health Insurance Portability and Accountability Act of
1996 provides an exclusion from gross income as an amount paid by
reason of the death of an insured for amounts received under a life
insurance contract and for amounts received for the sale or
assignment of a life insurance contract to a qualified viatical
settlement provider, provided that the insured under the life
insurance contract is either terminally ill or chronically ill.
The exclusion does not apply in the case of an amount paid to
any taxpayer other than the insured, if such taxpayer has an
insurable interest by reason of the insured being a director,
officer, or employee of the taxpayer, or by reason of the insured
being financially interested in any trade or business carried on by
the taxpayer.
A terminally ill individual is defined as one who has been
certified by a physician as having an illness or physical condition
that reasonably can be expected to result in death within 24 months
of the date of certification.
A chronically ill individual has the same meaning as provided
under the long-term care rules (see below). In the case of a
chronically ill individual, the exclusion with respect to amounts
paid under a life insurance contract and amounts paid in a sale or
assignment to a viatical settlement provider applies if the payment
received is for costs incurred by the payee (not compensated by
insurance or otherwise) for qualified long-term care services for
the insured person for the period, and two other requirements
(similar to requirements applicable to long-term care insurance
contracts) are met.
The first requirement is that under the terms of the contract
giving rise to the payment, the payment is not a payment or
reimbursement of expenses reimbursable under Medicare (except where
Medicare is a secondary payor under the arrangement, or the
arrangement provides for per diem or other periodic payments without
regard to expenses for qualified long-term care services). No
provision of law shall be construed or applied so as to prohibit the
offering of such a contract giving rise to such a payment on the basis
that the contract coordinates its payments with those provided under
Medicare. The second requirement is that the arrangement complies
with the consumer protection provisions applicable to long-term
care insurance contracts and issuers that are specified in
Treasury regulations.
Long-Term Care Insurance
Exclusion of Long-Term Care Insurance Proceeds-The Health
Insurance Portability and Accountability Act of 1996 provides that a
long-term care insurance contract generally is treated as an accident
and health insurance contract. Amounts (other than policyholder
dividends or premium refunds) received under a long-term care
insurance contract generally are excludable as amounts received for
personal injuries and sickness, subject to a dollar cap on aggregate
payments under per diem contracts. A reporting requirement applies
to payors of excludable amounts.
The amount of the dollar cap on aggregate payments under per
diem contracts with respect to any one chronically ill individual
(who is not also terminally ill) is $220 per day for calendar year
2003 ($80,520 annually) as indexed,4 reduced by the amount of
reimbursements and payments received by anyone for the cost of
qualified long-term care services for the chronically ill individual.
If more than one payee receives payments with respect to any one
chronically ill individual, then everyone receiving periodic payments
with respect to the same insured is treated as one person for purposes
of the dollar cap. The amount of the dollar cap is used first by the
chronically ill person, and any remaining amount is to be allocated
in accordance with Treasury regulations. If payments under such
contracts exceed the dollar cap, then the excess is excludable only
to the extent of actual costs (in excess of the dollar cap) incurred
for long-term care services. Amounts in excess of the dollar cap, with
respect to which no actual costs were incurred for long-term care
services, are fully includible in income without regard to rules
relating to return of basis under section 72. A grandfather rule
applies to any per diem-type contract issued to a policyholder on
or before July 31, 1996.
Exclusion for Employer-Provided Long-Term Care Coverage-A plan
of an employer providing coverage under a long-term care insurance
contract generally is treated as an accident and health plan. Thus,
employer-provided long-term care coverage is generally excludable from
income and wages and deductible by the employer. Employer-provided
coverage under a long-term care insurance contract is not, however,
excludable by an employee if provided through a cafeteria plan;
similarly, expenses for long-term care services cannot be reimbursed
under a flexible spending arrangement.
Definition of Long-Term Care Insurance Contract-A long-term
care insurance contract is defined as any insurance contract that
provides only coverage of qualified long-term care services and that
meets other requirements. The other requirements are that: (1) the
contract is guaranteed renewable; (2) the contract does not provide
for a cash surrender value or other money that can be paid, assigned,
pledged or borrowed; (3) refunds (other than refunds on the death of
the insured or complete surrender or cancellation of the contract)
and dividends under the contract may be used only to reduce future
premiums or increase future benefits; and (4) the contract generally
does not pay or reimburse expenses reimbursable under Medicare
(except where Medicare is a secondary payor, or the contract makes
per diem or other periodic payments without regard to expenses).
A contract does not fail to be treated as a long-term care
insurance contract solely because it provides for payments on a per
diem or other periodic basis without regard to expenses incurred
during the period.
Medicare Duplication Rules-No provision of law may be
applied to prohibit the offering of a long-term care insurance
contract on the basis that the contract coordinates its benefits
with those provided under Medicare.
Definition of Qualified Long-Term Care Services-Qualified
long-term care services means necessary diagnostic, preventive,
therapeutic, curing, treating, mitigating and rehabilitative
services, and maintenance or personal care services that are
required by a chronically ill individual and that are provided
pursuant to a plan of care prescribed by a licensed health care
practitioner.
Chronically Ill Individual-A chronically ill individual
is one who has been certified within the previous 12 months by a
licensed health care practitioner as: (1) being unable to perform
(without substantial assistance) at least two activities of daily
living for at least 90 days due to a loss of functional capacity;
(2) having a similar level of disability as determined by the
Secretary of the Treasury in consultation with the Secretary of
Health and Human Services; or (3) requiring substantial
supervision to protect such individual from threats to health
and safety due to severe cognitive impairment. Activities of daily
living are eating, toileting, transferring, bathing, dressing and
continence. For purposes of determining whether an individual is
chronically ill, the number of activities of daily living that are
taken into account under the long-term care insurance contract may
not be less than five.
Expenses for Long-Term Care Services Treated as Medical
Expenses-Unreimbursed expenses for qualified long-term care services
provided to the taxpayer or the taxpayer's spouse or dependents are
treated as medical expenses for purposes of the itemized deduction
for medical expenses (subject to the present-law floor of 7.5 percent
of AGI). For this purpose, amounts received under a long-term care
insurance contract (regardless of whether the contract reimburses
expenses or pays benefits on a per diem or other periodic basis) are
treated as reimbursement for expenses actually incurred for medical
care.
For purposes of the deduction for medical expenses, qualified
long-term care services do not include services provided to an
individual by a relative or spouse (directly, or through a
partnership, corporation, or other entity), unless the relative is a
licensed professional with respect to such services, or by a
related corporation (within the meaning of Code section 267(b) or
707(b)).
Long-Term Care Insurance Premiums Treated as Medical
Expenses-Long-term care insurance premiums that do not exceed
specified dollar limits are treated as medical expenses for purposes
of the itemized deduction for medical expenses.
Consumer Protection Provisions-Certain consumer protection
provisions apply with respect to the terms of a long-term care
insurance contract, for purposes of determining whether the contract
is a qualified long-term care insurance contract. In addition, certain
consumer protection provisions apply to issuers of long-term care
insurance contracts.
DEDUCTION FOR HEALTH INSURANCE EXPENSES OF SELF-EMPLOYED INDIVIDUALS
Self-employed individuals may currently deduct 100 percent of
their health insurance expenses for themselves and their spouses and
dependents. The deduction also applies to certain long-term care
premiums treated as medical expenses.
EXCLUSION OF MEDICARE BENEFITS
LEGISLATIVE HISTORY
The exclusion from income of Medicare benefits has never been
expressly established by statute. A 1970 IRS ruling, Rev. Rul. 70-341,
1970-2 C.B. 31, provided that the benefits under part A of Medicare
are not includible in gross income because they are disbursements
made to further the social welfare objectives of the Federal
Government. The Internal Revenue Service relied on a similar ruling,
Rev. Rul. 70-217, 1970-1 C.B. 13, with respect to the excludability of
Social Security disability insurance benefits in reaching this
conclusion. (For background on the exclusion of Social Security
benefits, see above section on pension contributions.) Rev. Rul.
70-341 also held that benefits under part B of Medicare are excludable
as amounts received through accident and health insurance (though the
subsidized portion of part B also may be excluded under the same
theory applicable to the exclusion of part A benefits).
EXPLANATION OF PROVISION
Benefits under part A and part B of Medicare are excludable
from the gross income of the recipient. In general, part A pays for
certain inpatient hospital care, skilled nursing facility care, home
health care, and hospice care for eligible individuals (generally the
elderly and the disabled). Part B covers certain services of a
physician and other medical services for elderly or disabled
individuals who elect to pay the required premium.
DEDUCTIBILITY OF MEDICAL EXPENSES
LEGISLATIVE HISTORY
An itemized deduction for unreimbursed medical expenses above
a specified floor has been allowed since 1942. From 1954 through 1982,
the floor under the medical expense deduction was 3 percent of the
taxpayer's adjusted gross income (AGI); a separate floor of 1 percent
of AGI applied to expenditures for medicine and drugs.
In the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA),
the floor was increased to 5 percent of AGI (effective for 1983 and
thereafter) and was applied to the total of all eligible medical
expenses, including prescription drugs and insulin. TEFRA made
nonprescription drugs ineligible for the deduction and eliminated the
separate floor for drug costs.
The Tax Reform Act of 1986 increased the floor under the
medical expense deduction to 7.5 percent of AGI, beginning in 1987.
EXPLANATION OF PROVISION
Individuals who itemize deductions may deduct amounts they pay
during the taxable year, if not reimbursed by insurance or otherwise,
for medical care of the taxpayer and of the taxpayer's spouse and
dependents, to the extent that the total of such expenses exceeds
7.5 percent of AGI (sec. 213).
Medical care expenses eligible include: (1) health insurance
(including after-tax employee contributions to employer health plans);
(2) diagnosis, treatment, or prevention of disease, or for the purpose
of affecting any structure or function of the body; (3) transportation
primarily for and essential to medical care; (4) lodging away from
home primarily for and essential to medical care, up to $50 per night;
and (5) prescription drugs and insulin.
Expenses paid for the general improvement of health, such as
fees for exercise programs, are not eligible for the deduction unless
prescribed by a physician to treat a specific illness. A deduction is
not allowed for cosmetic surgery or similar procedures that do not
meaningfully promote the proper function of the body or treat disease.
However, such expenses are deductible if the cosmetic procedure is
necessary to correct a deformity arising from a congenital abnormality,
an injury resulting from an accident, or disfiguring
disease.
Medical expenses are not subject to the general limitation on
itemized deductions applicable to taxpayers with AGIs above a certain
limit ($139,500 for 2003, and adjusted annually for inflation.
EFFECT OF PROVISION
The Tax Code allows taxpayers to claim an itemized deduction
if unreimbursed medical expenses absorb a substantial portion of
income and thus adversely affect the taxpayer's ability to pay taxes.
In order to limit the deduction to extraordinary expenses, medical
expenses are deductible only to the extent that they exceed 7.5
percent of the taxpayer's AGI.
Table 13-10 shows the effect on medical expense deductions
of the increases in the floor on medical deductions. In the absence
of those increases, one would have expected the number of taxpayers
claiming the deduction to have increased because of inflation of
medical costs. However, increasing the floor should reduce the number
of taxpayers claiming the deduction because many taxpayers with
relatively modest expenses no longer qualify. Taxpayers in higher
tax rate brackets receive more of a benefit from each dollar of
deductible medical expense than do taxpayers in lower tax rate
brackets. However, because the floor automatically rises with a
taxpayer's income, higher income taxpayers are able to deduct a
smaller amount (if any) of medical expenses above their floor than
are low-income taxpayers incurring the same aggregate amount of
medical expenses (Table 13-11).
TABLE 13-10 -- TAX RETURNS CLAIMING DEDUCTIBLE MEDICAL AND DENTAL
EXPENSES, 1980-2000
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-11 -- DISTRIBUTION OF ITEMIZED DEDUCTIONS FOR MEDICAL
EXPENSES, 2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
EARNED INCOME CREDIT
LEGISLATIVE HISTORY
The earned income credit (EIC; Code sec. 32), enacted in 1975,
generally equals a specified percentage of wages up to a maximum
dollar amount. The maximum amount applies over a certain income
range and then diminishes to zero over a certain income range. The
income ranges and percentages have been revised several times since
original enactment, expanding the credit (Table 13-12).
In 1987, the credit was indexed for inflation. In 1990 and
again in 1993, Congress enacted substantial expansions of the credit.
Auxiliary credits were added for very young children and for health
insurance premiums paid on behalf of a qualifying child in 1990.
They were repealed in 1993. Also, in 1993, eligibility for the
credit was expanded to include childless workers. The Personal
Responsibility and Work Opportunity Reconciliation Act of 1996
incorporated new rules relating to taxpayer identification numbers
and modified AGI phase-out of the credit in addition to amending the
credit's unearned income test (described below).
The Taxpayer Relief Act of 1997 also included provisions to
improve compliance. The provisions: (1) deny the EIC for 10 years to
taxpayers who fraudulently claimed the EIC, 2 years for EIC claims
which are a result of reckless or intentional disregard of rules or
regulations); (2) require EIC recertification for a taxpayer who is
denied the EIC; (3) imposes due diligence requirements on paid
preparers of returns involving the EIC; (4) requires information
sharing between the Treasury Department and State and local
governments regarding child support orders; and (5) allows expanded
use of Social Security Administration records to enforce the tax
laws, including the EIC. The Balanced Budget Act of 1997 also
increased the IRS authorization to improve enforcement of the EIC.
EGTRRA made several changes to the EIC to provide marriage
penalty relief and promote simplification, including: (1) increasing
the beginning and ending amounts of the phase out ranges by $1,000
(for 2002-2004), $2,000 (for 2005-2007), and $3,000 (in 2007, indexed
thereafter) for married taxpayers who file a joint return; (2)
excluding nontaxable employee compensation from the definition of
earned income; (3) repealing the reduction of the EIC by the amount
of an individual's alternative minimum tax; (4) eliminating the need
to calculate modified adjusted gross income for EIC purposes; (5)
expanding the relationship test for purposes of qualifying child,
and eliminating the requirement that certain individuals have the
same principal place of abode as the taxpayer for the entire year;
(6) simplifying the tie-breaker rule that applies if multiple
taxpayers claim the same qualifiying child; and (7) effective
January 1, 2004, with respect to noncustodial parents, expanding
the math error authority of the Internal Revenue Service based on
the Federal Case Registry of Child Support Orders.
EXPLANATION OF PROVISION
The EIC is available to low-income working taxpayers. Three
separate schedules apply.
Taxpayers with one qualifying child may claim a credit in
2003 of 34 percent of their earnings up to $7,490, resulting in a
maximum credit of $2,547. The maximum credit is available for those
with earnings between $7,490 and $13,730 ($14,730 if married filing
jointly). The credit begins to phase down at a rate of 15.98 percent
of earnings above $13,730 ($14,730 if married filing jointly). The
credit is phased down to $0 at $33,692 of earnings ($34,692 if
married filing jointly).
Taxpayers with more than one qualifying child may claim a
credit in 2003 of 40 percent of earnings up to $10,510, resulting in
a maximum credit of $4,204. The maximum credit is available for
those with earnings between $10,510 and $13,730 ($14,720 if married
filing jointly). The credit begins to phase down at a rate of 21.06
percent of earnings above $13,730 ($14,730 if married filing jointly).
The credit is phased down to $0 at $33,692 of earnings ($34,692 if
married filing jointly).
Taxpayers with no qualifying children may claim a credit if
they are over age 24 and below age 65. The credit is 7.65 percent of
earnings up to $4,990, resulting in a maximum credit of $382. The
maximum credit is available for those with incomes between $4,990 and
$6,240 ($7,240 if married filing jointly). The credit begins to
phase down at a rate of 7.65 percent of earnings above $6,240 ($7,240
if married filing jointly) resulting in a $0 credit at $11,230 of
earnings ($12,230 if married filing jointly).
All income thresholds are indexed for inflation annually.
In order to be a qualifying child, an individual must satisfy a
relationship test, a residency test, and an age test. The relationship
test requires that the individual be (1) a child, stepchild, or
descendant of a child or of a sibling or stepsibling. The residency
test requires that the individual have the same place of abode as the
taxpayer for more than half the taxable year. The households must be
located in the United States. The age test requires that the
individual be under 19 (24 for a full time student) or be permanently
and totally disabled.
TABLE 13-12 -- EARNED INCOME CREDIT PARAMETERS, 1975-2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
An individual is not eligible for the EIC if the aggregate
amount of disqualified income of the taxpayer for the taxable year
exceeds $2,600 (for 2003). This threshold is indexed. Disqualified
income is the sum of:
1. Interest (taxable and tax exempt),
2. Dividends,
3. Net rent and royalty income (if greater than zero),
4. Capital gains net income, and
5. Net passive income (if greater than zero) that is not
self-employment income.
For taxpayers with earned income (or AGI, if greater) in
excess of the beginning of the phaseout range, the maximum EIC amount
is reduced by the phaseout rate multiplied by the amount of earned
income (or AGI, if greater) in excess of the beginning of the
phaseout range. For taxpayers with earned income (or AGI, if greater)
in excess of the end of the phaseout range, no credit is allowed.
Individuals are ineligible for the credit if they do not
include their taxpayer identification number and their qualifying
child's number (and, if married, their spouse's taxpayer
identification number) on their tax return. Solely for these purposes
and for purposes of the present-law identification test for a
qualifying child, a taxpayer identification number is defined as a
Social Security number issued to an individual by the Social Security
Administration other than a number issued under section 205(c)(2)(B)
(i)(II) (or that portion of sec. 205(c)(2)(B)(i)(III) relating to it)
of the Social Security Act regarding the issuance of a number to an
individual applying for or receiving federally funded benefits.
If an individual fails to provide a correct taxpayer
identification number, such omission will be treated as a mathematical
or clerical error by the Internal Revenue Service. Similarly, if an
individual who claims the credit with respect to net earnings from
self-employment fails to pay the proper amount of self-employment tax
on such net earnings, the failure will be treated as a mathematical
or clerical error for purposes of the amount of credit allowed.
The EIC is relatively unique because it is a refundable tax
credit; i.e., if the amount of the credit exceeds the taxpayer's
Federal income tax liability, the excess is payable to the taxpayer
as a direct transfer payment. In this sense, the EIC is like other
Federal programs that provide poor and low-income families with
public benefits. However, the EIC differs from other Federal programs
in that its benefits require earnings.
Under an advance payment system, available since 1979,
eligible taxpayers may elect to receive the credit in their
paychecks, rather than waiting to claim a refund on their tax return
filed by April 15 of the following year. In 1993, Congress required
that the IRS begin to notify eligible taxpayers of the advance
payment option.
INTERACTION WITH MEANS-TESTED PROGRAMS
The treatment of the EIC for purposes of Aid to Families with
Dependent Children (AFDC) and food stamp benefit computations has
varied since inception of the credit. When enacted in 1975, the
credit was not considered income in determining AFDC and food stamp
benefits, and the credit could not be received on an advance basis.
From January 1979 through September 1981, the credit was treated as
earned income when actually received.
From October 1981 to September 1984, the amount of the
credit was treated as earned income and was imputed to the family
even though it may not have been received as an advance payment.
Pursuant to the Deficit Reduction Act of 1984, the credit was treated
as earned income only when received, either as an advance payment or
as a refund after the conclusion of the year.
Under the Family Support Act of 1988, States generally were
required to disregard any advance payment or refund of the EIC when
calculating AFDC eligibility or benefits. However, the credit was
counted against the gross income eligibility standard (185 percent
of the State need standard) for both applicants and recipients.
OBRA 1990 specified that, effective January 1, 1991, the EIC
was not to be taken into account as income (for the month in which
the payment is received or any following month) or as a resource (for
the month in which the payment is received or the following month) for
determining the eligibility or amount of benefit for AFDC, Medicaid,
SSI, food stamps, or low-income housing programs.
EFFECT OF PROVISION
More than 19.2 million taxpayers are expected to take advantage
of the EIC for 2003 (Table 13-13). Their claims are expected to total
$34 billion, approximately 90 percent of which will be refunded as
direct payments to these families (Table 13-14). As Table 13-13 also
shows, approximately 75 percent of the tax relief or direct spending
from the EIC accrues to taxpayers who file as singles or heads of
households.
Table 13-14 shows the total amount of EIC received for each
of the calendar years since the inception of the program, the number
of recipient families, the amount of the credit received as refunded
payments, and the average amount of credit received per family.
TABLE 13-13 -- DISTRIBUTION OF EARNED INCOME CREDIT, 2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-14 -- EARNED INCOME CREDIT: NUMBER OF RECIPIENTS
AND AMOUNT OF CREDIT, 1975-2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
EXCLUSION OF PUBLIC ASSISTANCE AND SSI BENEFITS
LEGISLATIVE HISTORY
While there is no specific statutory authorization, a number
of revenue rulings under Code section 61 have held that specific
types of public assistance payments are excludable from gross income.
Revenue rulings generally exclude government transfer payments from
income because they are considered to be general welfare payments.
In addition, taxing benefits provided in kind, rather than in cash,
would require valuation of these benefits, which could create
administrative difficulties.
EXPLANATION OF PROVISION
The Federal Government provides tax-free public assistance
benefits to individuals either by cash payments or by provision of
certain goods and services at reduced cost or free of charge. Cash
payments come mainly from the AFDC and Supplemental Security Income
(SSI) Programs. Inkind payments include food stamps, Medicaid, and
housing assistance. None of these payments is subject to income tax.
DEPENDENT CARE TAX CREDIT
LEGISLATIVE HISTORY
Under section 21 of the Internal Revenue Code, taxpayers are
allowed an income tax credit for certain employment-related expenses
for dependent care. The Internal Revenue Code of 1954 provided a
deduction to gainfully employed women, widowers, and legally separated
or divorced men for certain employment-related dependent care expenses.
The deduction was limited to $600 per year and phased out for families
with incomes between $4,500 and $5,100.
The Revenue Act of 1964 made husbands with incapacitated wives
eligible for the dependent care deduction and raised the threshold for
the income phaseout from $4,500 to $6,000.
The Revenue Act of 1971: (1) made any individual who maintained
a household and was gainfully employed eligible for the deduction; (2)
modified the definition of a dependent; (3) raised the deduction limit
to $4,800 per year; (4) increased from $6,000 to $18,000 the income
level at which the deduction began to phase out; (5) allowed the
deduction for household services in addition to direct dependent care;
and (6) limited the deduction with respect to services outside the
taxpayer's household.
The Tax Reduction Act of 1975 increased from $18,000 to
$35,000 the income level at which the deduction began to be phased
out.
The Tax Reform Act of 1976 replaced the deduction with a
nonrefundable credit. This change broadened eligibility to those who
do not itemize deductions and provided relatively greater benefit to
low-income taxpayers. In addition, the act eased the rules related to
family status and simplified the computation.
In the Economic Recovery Tax Act of 1981, Congress provided
a higher ceiling on creditable expenses, a larger credit for low-
income individuals, and modified rules relating to care provided
outside the home.
The Family Support Act of 1988 reduced to 13 the age of a
child for whom the dependent care credit may be claimed, reduced the
amount of eligible expenses by the amount of expenses excludable from
that taxpayer's income under the dependent care exclusion, lowered
from five to two the age at which a taxpayer identification number
had to be submitted for children for whom the credit was claimed,
and disallowed the credit unless the taxpayer reports on her tax
return the correct name, address, and taxpayer identification number
(generally, an employer identification number or a Social Security
number) of the dependent care provider.
The Small Business Job Protection Act of 1996 required a
TIN for all children for whom a dependent care credit may be claimed.
EGTRRA increased the credit rate for lower-income taxpayers,
as well as the maximum eligible expense amount for the credit for all
taxpayers.
EXPLANATION OF PROVISION
A taxpayer may claim a nonrefundable credit against income
tax liability for up to 35 percent of a limited amount of employment-
related dependent care expenses. Eligible employment-related expenses
are limited to $3,000 if there is one qualifying dependent or $6,000
if there are two or more qualifying dependents. Generally, a
qualifying individual is a dependent under the age of 13 or a
physically or mentally incapacitated dependent or spouse.
Employment-related dependent care expenses are expenses for
the care of a qualifying individual incurred to enable the taxpayer
to be gainfully employed, other than expenses incurred for an
overnight camp. For example, amounts paid for the services of a
housekeeper generally qualify if such services are performed at
least partly for the benefit of a qualifying individual; amounts paid
for a chauffeur or gardener do not qualify.
Expenses that may be taken into account in computing the
credit generally may not exceed an individual's earned income or, in
the case of married taxpayers, the earned income of the spouse with
the lesser earnings. Thus, if one spouse is not working, no credit
generally is allowed. Also, the amount of expenses eligible for the
dependent care credit is reduced, dollar for dollar, by the amount
of expenses excludable from that taxpayer's income under the
dependent care exclusion (discussed below).
The 35-percent credit rate is reduced, but not below 20
percent, by 1 percentage point for each $2,000 (or fraction thereof)
of AGI above $15,000. Because married couples are required to file a
joint return to claim the credit, a married couple's combined AGI
is used for purposes of this computation.
EFFECT OF PROVISION
From 1976 to 2001, the number of families that claimed the
dependent care credit increased from 2.7 to a projected 6.3 million,
the aggregate amount of credits claimed increased from $0.5 to $2.7
billion, and the average amount of credit claimed per family
increased from $206 to $440 (table 13-15).
Changes made in the Family Support Act of 1988 reduced the
use of the credit in 1989. The number of families who claimed the
credit dropped by about one-third and the amount of credit claimed
declined by $1.373 billion.
Data for 1997 from the Internal Revenue Service show that
about 10 percent of the benefit from the credit accrues to families
with AGI of less than $20,000; about 42 percent to families with AGI
between $20,000 and $50,000; and about 48 percent to families with
AGI above $50,000.
TABLE 13-15 -- DEPENDENT CARE TAX CREDIT: NUMBER OF FAMILIES AND
AMOUNT OF CREDIT, 1976-2001
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
HOPE CREDIT AND LIFETIME LEARNING CREDIT
The Taxpayer Relief Act of 1997 established the HOPE credit
and the lifetime learning credit as nonrefundable credits against
Federal income tax liability for qualified tuition and fees required
for the attendance of an eligible student at an eligible educational
institution.
The HOPE credit rate is 100 percent of the first $1,000 of
qualified tuition and fees per eligible student per year, and
50 percent of the next $1,000 of qualified tuition and fees per
eligible student per year. The HOPE credit is available only for the
first two years of postsecondary education. The qualified tuition and
fees must be incurred on behalf of the taxpayer, the taxpayer's
spouse, or a dependent. Charges and fees associated with meals,
lodging, books, student activities, athletics, insurance,
transportation, and similar personal, living, or family expenses are
not eligible for the credit. An eligible student for purposes of the
HOPE credit is a student enrolled in a degree, certificate, or other
program on at least a half-time basis. Eligible educational
institutions are defined by reference to section 481 of the Higher
Education Act of 1965. Such institutions generally are accredited
postsecondary educational institutions offering credit toward a
bachelor's degree, an associate's degree, or another recognized
postsecondary credential. Certain proprietary institutions and
postsecondary vocational institutions are also eligible educational
institutions. The $1,500 maximum HOPE credit amount is indexed for
inflation.
The lifetime learning credit rate is 20 percent of up to
$10,000 in qualified tuition and fees for a maximum credit of $2,000.
In contrast to the HOPE credit, the lifetime learning credit is
available for an unlimited number of years of education. Also in
contrast to the HOPE credit, which requires a half-time or greater
enrollment status, the lifetime learning credit is available with
respect to any course of instruction at an eligible educational
institution to acquire or improve job skills, regardless of
enrollment status. Qualified tuition and fees are defined in the
same manner as under the HOPE credit provisions. As with the HOPE
credit, eligible students are the taxpayer, the taxpayer's spouse,
or a dependent. In contrast to the HOPE credit, the maximum amount of
the lifetime learning credit that may be claimed on a taxpayer's
return will not vary with the number of students in the taxpayer's
family. The maximum lifetime learning credit amount is not indexed
for inflation.
Eligibility for the HOPE credit and the lifetime learning
credit is phased out ratably for taxpayers with modified adjusted
gross income (AGI) between $41,000 and $51,000 ($83,000 and $103,000
for joint returns). These phase-outs are indexed for inflation.
For a taxable year, a taxpayer may elect with respect to an eligible
student either the HOPE credit, the lifetime learning credit, or the
deduction for qualified tuition and related expenses. For purposes
of both the HOPE credit and the lifetime learning credit, if a
parent claims a child as a dependent, then only the parent may
claim the credit.
QUALIFIED TUITION PROGRAMS AND COVERDELL EDUCATION
SAVINGS ACCOUNTS
The Taxpayer Relief Act of 1997 and EGTRRA modified
section 529 of the Tax Code, which governs the tax treatment of
qualified tuition programs. Section 529 was enacted as part of the
Small Business Job Protection Act of 1996, and provided tax-exempt
status and deferral of tax on earnings of qualified State tuition
programs. The Taxpayer Relief Act of 1997 also provided that taxpayers
may establish education IRAs. (Renamed Coverdell Education Savings
Accounts by P.L. 107-22). EGTRRA extended the provisions to programs
established by eligible education institutions.
Qualified State tuition programs are programs established
and maintained by a State or agency or instrumentality thereof or by
one or more eligible educational institutions under which persons
may: (1) purchase tuition credits or certificates on behalf of a
designated beneficiary that entitle the beneficiary to a waiver or
payment of qualified higher education expenses of the beneficiary;
or (2) in the case of a program established by a State agency or
instrumentality thereof make contributions to an account that is
established for the purpose of meeting qualified higher education
expenses of a designated beneficiary. Qualified higher education
expenses are defined as tuition, fees, books, supplies, and equipment
required for the enrollment of or attendance at a college or
university (or certain vocational schools). The Taxpayer Relief Act
of 1997 expanded the definition of qualified expenses to include
room and board expenses. Contributions to qualified tuition programs
are not deductible. EGTRRA provided that earnings on qualified
tuition programs are not includible in income if used for qualified
expenses. Distributions from a qualified tuition program also
entitle the distributee to claim either the HOPE or the lifetime
learning credit with respect to education expenses paid with such
distributions, assuming the other requirements for claiming the HOPE
credit or the lifetime learning credit are satisfied. There are no
income limits for participation in qualified tuition programs,
though contributions must be limited by the program to amounts no
greater than an amount necessary to provide for the education of
the beneficiary. Withdrawals of earnings that are not used for
qualified expenses are includible in income and also are subject
to an additional 10 percent tax.
A Coverdell Education Savings Account is a trust or custodial
account created exclusively for the purpose of paying qualified
higher education expenses of a named beneficiary. Contributions to
a Coverdell Education Savings Account are not deductible; earnings
on contributions are not currently includable in income. Contributions
to a Coverdell education savings account are limited to $2,000 per
year per beneficiary. The contribution limit is phased out ratably
for contributions with modified AGI between $95,000 and $110,000
($190,000 and $220,000 for joint returns). With respect to post-
secondary education, qualified expenses are the same as those for
qualified tuition programs. Qualified expenses also include
elementary and secondary education expenses. Qualified elementary
and secondary education expenses include tuition, fees, academic
tutoring, special needs services, books, supplies, room and board,
and education-related computer equipment and software. Withdrawals
of earnings from education IRAs are excludable from income provided
that such withdrawals are used to pay for qualified higher education
expenses. If the earnings are not used for qualified expenses, they
are includable in income and are also subject to an additional
10-percent penalty tax.
STUDENT LOAN INTEREST DEDUCTION
The Taxpayer Relief Act of 1997 provided for the above-the-
line deductibility of interest on qualified education loans. A
qualified education loan is generally defined as any indebtedness
incurred to pay for the qualified higher education expenses of the
taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as
of the time the indebtedness was incurred in attending either
postsecondary educational institutions and certain vocational schools
defined by reference to section 481 of the Higher Education Act of
1965, or institutions conducting internship or residency programs
leading to a degree or certificate from an institution of higher
education, a hospital, or a health care facility conducting
postgraduate training. Qualified higher education expenses are
defined as the student's cost of attendance as defined in section
472 of the Higher Education Act of 1965 (generally, tuition, fees,
room and board, and related expenses), reduced by: (1) any amount
excluded under section 135 (i.e., U.S. saving bonds used to pay
higher education tuition and fees); (2) any amount distributed from
a Coverdell education savings account or qualified tuition program
and excluded from gross income; and (3) the amount of any scholarship
or fellowship grants excludable from gross income under section 117,
as well as any other tax-free education benefits, such as employer-
provided educational assistance that is excludable from the
employee's gross income under section 127.
The maximum deduction is $2,500 and is not indexed for
inflation. This deduction is phased out ratably for individuals
with modified AGI of $50,000-$65,000 ($100,000 and $130,000 for
joint returns). These income ranges are indexed for inflation and
rounded down to the closest multiple of $5,000.
QUALIFIED TUITION DEDUCTION
The Economic Growth and Tax Relief Reconciliation Act of 2001 added
an above-the-line deduction for qualified tuition and related expenses
paid by the taxpayer during a taxable year. Qualified expenses are
defined in the same manner as for the purposes of the HOPE credit.
In 2002 and 2003, taxpayers with adjusted gross income that does not
exceed $65,000 ($130,000 in the case of married couples filing joint
returns) are entitled to a maximum deduction of $3,000 per year.
Taxpayers with adjusted gross income above these thresholds would
not be entitled to a deduction. In 2004 and 2005, taxpayers with
adjusted gross income that does not exceed $65,000 ($130,000 in the
case of married taxpayers filing joint returns) are entitled to a
maximum deduction of $4,000 and taxpayers with adjusted gross income
that does not exceed $80,000 ($160,000 in the case of married
taxpayers filing joint returns) are entitled to a maximum deduction
of $2,000. The deduction is not available in 2006 and thereafter.
Taxpayers are not eligible to claim the deduction and a HOPE or
Lifetime Learning Credit in the same year with respect to the same
student. A taxpayer may not claim a deduction for amounts taken
into account in determining the amount excludable due to a
distribution (i.e., the earnings and contribution portion of a
distribution) from a Coverdell education savings account or the
amount of interest excludable with respect to education savings
bonds. A taxpayer may not claim a deduction for the amount of a
distribution from a qualified tuition program that is excludable
from income; however, a taxpayer may claim a deduction for the
amount of a distribution from a qualified tuition program that is
not attributable to earnings.
EXCLUSION FOR EMPLOYER-PROVIDED DEPENDENT CARE
LEGISLATIVE HISTORY
The value of certain employer-provided dependent care is
excluded from the employee's gross income. The Economic Recovery
Tax Act of 1981 added this exclusion (sec. 129) and amended Code
sections 3121(a)(18) and 3306(b)(13) to exclude such employer-
provided dependent care from wages for purposes of the Federal
Insurance Contributions Act (FICA) and the Federal Unemployment
Tax Act (FUTA). The Tax Reform Act of 1986 modified the
nondiscrimination rules and limited the exclusion to $5,000 a
year ($2,500 in the case of a separate return by a married
individual). The Family Support Act of 1988 required the amount
of employer-provided dependent care excluded from the taxpayer's
income to reduce, dollar for dollar, the amount of expenses eligible
for the dependent care tax credit.
EXPLANATION OF PROVISION
Amounts paid or incurred by an employer for dependent care
assistance provided to an employee generally are excluded from the
employee's gross income if the assistance is furnished under a
program meeting certain requirements. These requirements include
that the program be described in writing, satisfy certain
nondiscrimination rules, and provide for notification to all
eligible employees. The type of dependent care eligible for the
exclusion is the same as the type eligible for the dependent
care credit.
The dependent care exclusion is limited to $5,000 per year
except that a married taxpayer filing a separate return may exclude
only $2,500. Amounts excluded from gross income generally are
excludable from wages for employment tax purposes. Dependent care
expenses excluded from income are not eligible for the dependent
care tax credit.
EFFECT OF PROVISION
The exclusion provides an incentive to taxpayers with
expenses for dependent care to seek compensation in the form of
dependent care assistance rather than in cash subject to taxation.
This incentive is of greater value to employees in higher tax
brackets.
Many employees covered by the exclusion for employer-
provided dependent care also are eligible to use the dependent care
tax credit. While the limitations on the exclusion and the credit
differ, the credit generally is less valuable than the exclusion
for taxpayers who are above the 15-percent tax bracket.
According to a survey of private firms with 100 or more
workers conducted by the U.S. Bureau of Labor Statistics (1993),
nearly one-tenth of full-time workers at these firms were eligible
for child care benefits provided by the employer in the form of
on-site or near-site child care facilities or through direct
reimbursement of employee expenses. A more prevalent form of
providing dependent care benefits is through reimbursement accounts,
which may cover other nontaxable fringe benefits, such as out-of-
pocket health care expenses, in addition to dependent care. Slightly
over one-third of full-time employees at large- and medium-sized
firms were eligible for such accounts in 1991.
WORK OPPORTUNITY TAX CREDIT
The work opportunity tax credit is available on an elective
basis for employers hiring individuals from one or more of eight
targeted groups. The targeted groups are: (1) families eligible to
receive benefits under the Title IV-A Temporary Assistance for Needy
Families Program (TANF; the successor to AFDC); (2) qualified
ex-felons; (3) vocational rehabilitation referrals; (4) qualified
summer youth employees; (5) qualified veterans; (6) youths who
reside in an empowerment zone or enterprise community; (7) families
receiving food stamps; and (8) persons receiving certain Supplemental
Security Income (SSI) benefits.
The credit generally is equal to 40 percent (25 percent for
employment of 400 hours or less) of qualified wages. Qualified wages
consist of wages attributable to service rendered by a member of a
targeted group during the 1-year period beginning with the day the
individual begins work for the employer. For a vocational
rehabilitation referral, however, the period will begin on the day
the individual begins work for the employer on or after the beginning
of the individual's vocational rehabilitation plan as under prior
law.
Generally, no more than $6,000 of wages during the first
year of employment is permitted to be taken into account with
respect to any individual.
Thus, the maximum credit per individual is $2,400. With
respect to qualified summer youth employees, the maximum credit is
40 percent of up to $3,000 of qualified first-year wages, for a
maximum credit of $1,200.
In general, an individual is not to be treated as a member
of a targeted group unless: (1) on or before the day the individual
begins work for the employer, the employer received in writing a
certification from the designated local agency that the individual
is a member of a specific targeted group; or (2) on or before the
day the individual is offered work with the employer, a prescreening
notice is completed with respect to that individual by the employer
and within 21 days after the individual begins work for the employer,
the employer submits such notice, signed by the employer and the
individual under penalties of perjury, to the designated local agency
as part of a written request for certification. The prescreening
notice will contain the information provided to the employer by the
individual that forms the basis of the employer's belief that the
individual is a member of a targeted group.
No credit is allowed for wages paid unless the eligible
individual is employed by the employer for at least 120 hours. The
credit percentage is 25 percent for employment of 400 hours or less,
assuming that the minimum employment period is satisfied with respect
to that employee. For employment of more than 400 hours, the credit
percentage is 40 percent.
The credit is effective for wages paid or incurred to a
qualified individual who begins work for an employer after September
30, 1996, and before January 1, 2004.
WELFARE-TO-WORK TAX CREDIT
The Code provides to employers a tax credit on the first
$20,000 of eligible wages paid to qualified long-term family
assistance (TANF) recipients during the first 2 years of employment.
The credit is 35 percent of the first $10,000 of eligible wages in
the first year of employment and 50 percent of the first $10,000 of
eligible wages in the second year of employment. The maximum credit
is $8,500 per qualified employee.
Qualified long-term family assistance recipients are: (1)
members of a family that has received TANF benefits for at least 18
consecutive months ending on the hiring date; (2) members of a family
that has received TANF benefits for a total of at least 18 months
(whether or not consecutive) after the date of enactment of this
credit if they are hired within two years after the date that the
18-month total is reached; and (3) members of a family who are no
longer eligible for TANF because of either Federal or State time
limits, if they are hired within two years after the Federal or State
time limits made the family ineligible for family assistance.
Eligible wages include cash wages paid to an employee plus
amounts paid by the employer for the following: (1) educational
assistance excludable under a section 127 program (or that would be
excludable but for the expiration of sec. 127); (2) health plan
coverage for the employee, but not more than the applicable premium
defined under section 4980B(f)(4); and (3) dependent care assistance
excludable under section 129.
The welfare to work credit is effective for wages paid or
incurred to a qualified individual who begins work for an employer
on or after January 1, 1998, and before January 1, 2004.
EXCLUSION OF WORKERS' COMPENSATION AND SPECIAL
BENEFITS FOR DISABLED COAL MINERS
LEGISLATIVE HISTORY
Workers' compensation benefits generally are not taxable under
section 104(a)(1) of the Internal Revenue Code. Workers' compensation
benefits are treated as Social Security benefits to the extent that
they reduce Social Security benefits received (see above). This
exclusion from gross income was first codified in the Revenue Act of
1918. The Ways and Means Committee report for that act suggests that
such payments were not subject to tax even prior to the 1918 act.
Payments made to coal miners or their survivors for death or
disability resulting from pneumoconiosis (black lung disease) under
the Federal Coal Mine Health and Safety Act of 1969 (as amended) are
excluded from gross income. Payments made as a result of claims filed
before December 31, 1972, originally were excluded from Federal income
tax by the Federal Coal Mine Health and Safety Act of 1969. Later
payments are excluded from gross income because they are considered
to be in the nature of workers' compensation
(Rev. Rul. 72-400, 1972-2 C.B. 75).
EXPLANATION OF PROVISION
Gross income does not include amounts received as workers'
compensation for personal injuries or sickness. This exclusion also
applies to benefits paid under a workers' compensation act to a
survivor of a deceased employee.
Benefits for disabled coal miners (black lung benefits) are
not includable in gross income.
There are two types of black lung programs. The first
involves Federal payments to coal miners and their survivors due to
death or disability, payable for claims filed before July 1, 1973
(December 31, 1973, in the case of survivors). This program provided
total annual payments of around $672 million to approximately
143,000 beneficiaries in December 1995 (Social Security
Administration, 1996).
The second program requires coal mine operators to ensure
payment of black lung benefits for claims filed on or after July 1,
1973 (December 31, 1973, in the case of survivors) in a federally
mandated workers' compensation program. Benefits include medical
treatment as well as cash payments. These benefits are paid from a
trust fund financed by an excise tax on coal production if there is
no responsible operator (an operator for whom the miner worked for at
least 1 year) or if the responsible operator is in default. This
program provided total annual payments of around $610 million to
approximately 156,550 claimants in 1986 (U.S. Department of Labor,
1989, tables 3 & 6).
ADDITIONAL STANDARD DEDUCTION FOR THE ELDERLY AND BLIND
LEGISLATIVE HISTORY
From 1954 through 1986, an additional personal exemption was
allowed for a taxpayer or a spouse who was 65 years or older at the
close of the year. An additional personal exemption also was allowed
for a taxpayer or a spouse who was blind.
The Tax Reform Act of 1986 repealed the additional personal
exemption for the elderly and blind and replaced it with an additional
standard deduction amount. These additional standard deduction amounts
are adjusted for inflation.
EXPLANATION OF PROVISION
The additional standard deduction amount for the elderly or
the blind is $950 in 2003 for an elderly or a blind individual who is
married (whether filing jointly or separately) or is a surviving
spouse, and $1,900 for such an individual who is both elderly and
blind. The additional amount is $1,150 for a head of household who is
elderly or blind ($2,300, if both), and for a single individual (i.e.,
an unmarried individual other than a surviving spouse or head of
household) who is elderly or blind.
The definitions of elderly and blind status have not been
changed since 1954. An elderly person is an individual who is at least
65 years of age. Blindness is defined in terms of the ability to
correct a deficiency in distance vision or the breadth of the area of
vision. An individual is blind only if central vision acuity is not
better than 20/200 in the better eye with correcting lenses, or if
visual acuity is better than 20/200 but is accompanied by a limitation
in the fields of vision such that the widest diameter of the visual
field subtends an angle no greater than 20 degrees.
EFFECT OF PROVISION
In 2000, approximately 11.3 million taxpayers claimed the extra
standard deduction. About 76 percent of the 11.3 million beneficiaries
had incomes of less than $40,000.
TAX CREDIT FOR THE ELDERLY AND CERTAIN DISABLED
INDIVIDUALS
LEGISLATIVE HISTORY
The present tax credit for individuals who are age 65 or
older, or who have retired on permanent and total disability, was
enacted in the Social Security amendments of 1983 (Code sec. 22). This
credit replaced the previous credit for the elderly, which had been
enacted in the Tax Reform Act of 1976. Prior to that provision, the
tax law provided a retirement income credit, which initially was
enacted in the Internal Revenue Code of 1954.
EXPLANATION OF PROVISION
Individuals who are age 65 or older may claim a nonrefundable
income tax credit equal to 15 percent of a base amount. The credit
also is available to an individual, regardless of age, who is retired
on disability and who was permanently and totally disabled at
retirement. For this purpose, an individual is considered permanently
and totally disabled if he is unable to engage in any substantial
gainful activity by reason of any medically determinable physical or
mental impairment that can be expected to result in death, or that
has lasted or can be expected to last for a continuous period of not
less than 12 months. The individual must furnish proof of disability
to the IRS.
The maximum base amount for the credit is $5,000 for
unmarried elderly or disabled individuals and for married couples
filing a joint return if only one spouse is eligible; $7,500 for
married couples filing a joint return with both spouses eligible;
or $3,750 for married couples filing separate returns. For a
nonelderly, disabled individual the initial base amount is the
lesser of the applicable specified amount or the individual's
disability income for the year. Consequently, the maximum credit
available is $750 (15 percent of $5,000),
$1,125 (15 percent of $7,500), or $562.50 (15 percent of $3,750).
The maximum base amount is reduced by the amount of certain
nontaxable income of the taxpayer, such as nontaxable pension and
annuity income or nontaxable Social Security, railroad retirement,
or veterans' nonservice-related disability benefits. In addition,
the base amount is reduced by one-half of the taxpayer's AGI in
excess of certain limits: $7,500 for a single individual, $10,000
for married taxpayers filing a joint return, or $5,000 for married
taxpayers filing separate returns. These computational rules reflect
that the credit is designed to provide tax benefits to individuals
who receive only taxable retirement or disability income, or who
receive a combination of taxable retirement or disability income
plus Social Security benefits that generally are comparable to the
tax benefits provided to individuals who receive only Social
Security benefits (including Social Security disability benefits).
EFFECT OF PROVISION
In 2000, $33 million in elderly and disabled credit was
claimed. Though the number of families claiming the credit has fallen
significantly, the average credit granted has been relatively stable
since the credit was modified by the Social Security Amendments of
1983, as shown in Table 13-16.
TABLE 13-16 -- CREDIT FOR THE ELDERLY AND DISABLED 1976-2000
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TAX PROVISIONS RELATED TO HOUSING
OWNER-OCCUPIED HOUSING
Legislative History
Deductibility of Mortgage Interest-Prior to the Tax Reform
Act of 1986, all interest payments on indebtedness incurred for
personal use (e.g., to purchase consumption goods) were deductible in
computing taxable income. The 1986 act amended section 163(h) of the
Internal Revenue Code to disallow deductions for all personal interest
except for interest on indebtedness secured by a first or second home.
In the Omnibus Budget Reconciliation Act of 1987, Congress
further restricted the deductibility of mortgage interest. Only two
classes of interest were distinguished as deductible: interest on
acquisition indebtedness and interest on home equity indebtedness.
Acquisition indebtedness, defined as indebtedness secured by a
residence and used to acquire or improve the residence by which it is
secured, was limited to $1,000,000 ($500,000 in the case of a married
individual filing a separate return). Home equity indebtedness,
defined as any nonacquisition indebtedness secured by a residence
(for example, a home equity loan), was limited to the lesser of
$100,000 ($50,000 for married taxpayers filing separately) or the
excess of the fair market value of the residence over the
acquisition indebtedness.
Exclusion of Capital Gains for Certain Taxpayers.-In the
Revenue Act of 1964, Congress introduced section 121 of the Internal
Revenue Code of 1954, which permitted a one-time exclusion of all or
part of the gain on the sale of a principal residence by older
individuals. This exclusion was limited to homeowners who had lived
in the property as a principal residence for five out of the last
eight years before the property's sale or exchange. Furthermore, full
exclusion was permitted only for houses that sold for $20,000 or less.
The parameters of this exclusion have been modified and
expanded a number of times. Most recently, the Taxpayer Relief Act of
1997 significantly expanded the exclusion by repealing the age 55
requirements and one-time applicability, and increasing the maximum
excludible amount.
Explanation of Provision
Homeowners may deduct a number of expenses related to housing
as itemized deductions in computing taxable income. These include
payments of interest on qualified residence debt, certain interest
on home equity loans, certain payments of points (i.e., up front
interest payments) on the purchase of a house, and payments of real
property taxes. Interest on acquisition debt of $1,000,000 or less
is fully deductible, as is any interest on debt secured by a residence
that was incurred on or before October 13, 1987. Interest on home
equity indebtedness of $100,000 is fully deductible for regular tax
purposes, as long as the total amount of debt (acquisition plus home
equity indebtedness) does not exceed the fair market value of the
house. Interest on home equity indebtedness exceeding $100,000 (and
incurred after October 13, 1987) or exceeding the difference between
the fair market value of the home and the acquisition indebtedness is
not deductible. Interest paid on home equity loans is generally not
deductible in computing the alternative minimum tax.
Under present law, a taxpayer generally is able to exclude up
to $250,000 ($500,000 if married filing a joint return) of gain
realized on the sale or exchange of a principal residence. The
exclusion is allowed each time a taxpayer selling or exchanging a
principal residence meets the eligibility requirements, but generally
no more frequently than once every two years.
To be eligible for the exclusion, a taxpayer must have owned
the residence and occupied it as a principal residence for at least
two of the five years prior to the sale or exchange. A taxpayer who
fails to meet these requirements by reason of a change of place of
employment, health, or other unforeseen circumstances is able to
exclude the fraction of the $250,000 ($500,000 if married filing a
joint return) equal to the fraction of two years that these
requirements are met.
Effects of Provision
Preliminary tax return information for 2000 indicates that
35 million taxpayers claimed the deduction for mortgage interest.
Reliable data are not yet available on how many claimed the one-
time exclusion.
The favorable treatment of owner-occupied housing may
affect both the home ownership rate and the share of total investment
in housing in the United States.
The home ownership tax provisions may benefit neighborhoods
because they encourage home ownership and home improvement. The
United States has maintained a high rate of home ownership-66
percent of all American households own the homes they live in (U.S.
Census Bureau, 1999, p. 729, table 1212).
The tax advantages for owner-occupied housing encourage
people to invest in homes instead of taxable business investments.
This shift may reduce investment in business assets in the United
States. One study suggested that housing capital is 25 percent higher
and other capital is 12 percent lower than it would be if tax policy
provided equal treatment for all forms of capital (Mills, 1987).
Currently, about one-third of net private investment goes into owner-
occupied housing, so even a modest shift of investment to other
assets could have sizable effects.
LOW-INCOME HOUSING CREDIT
Legislative History
The low-income rental housing tax credit was first enacted
in the Tax Reform Act of 1986. The Omnibus Budget Reconciliation Act
of 1989 substantially modified the credit. The Omnibus Budget
Reconciliation Act of 1993 modified the credit again and made it
permanent. The Community Renewal Tax Relief Act of 2000 increased
and indexed the annual amount of allocable credits.
Explanation of Provision
A tax credit may be claimed by owners of residential rental
property used for low-income rental housing. The credit is claimed
annually, generally for a period of 10 years. New construction and
rehabilitation expenditures for low-income housing projects are
eligible for a maximum 70-percent present value credit, claimed
annually for 10 years. The acquisition cost of existing projects
that meet the substantial rehabilitation requirements and the cost
of newly constructed projects receiving other Federal subsidies
are eligible for a maximum 30-percent present value credit, also
claimed annually for 10 years. These credit percentages are adjusted
monthly based on an Applicable Federal Rate.
The credit amount is based on the qualified basis of the
housing units serving the low-income tenants. A residential rental
project will qualify for the credit only if: (1) 20 percent or more
of the aggregate residential rental units in the project are
occupied by individuals with 50 percent or less of area median
income; or (2) 40 percent or more of the aggregate residential rental
units in the project are occupied by individuals with 60 percent or
less of area median income. These income figures are adjusted for
family size. Maximum rents that may be charged families in units on
which a credit is claimed depend on the number of bedrooms in the
unit. The rent limitation is 30 percent of the qualifying income of a
family deemed to have a size of 1.5 persons per bedroom (e.g., a two-
bedroom unit has a rent limitation based on the qualifying income for
a family of three).
Credit eligibility also depends on the existence of a 30-year
extended low-income use agreement for the property. If property on
which a low-income housing credit is claimed ceases to qualify as
low-income rental housing or is disposed of before the end of a
15-year credit compliance period, a portion of the credit may be
recaptured. The 30-year extended use agreement creates a State law
right to enforce low-income use for an additional 15 years after the
initial 15-year recapture period.
In order for a building to be a qualified low-income building,
the building owner generally must receive a credit allocation from the
appropriate credit authority. An exception is provided for property
that is substantially financed with the proceeds of tax-exempt bonds
subject to the State's private-activity bond volume limitation. The
low-income housing credit is allocated by State or local government
authorities subject to an annual limitation for each State based on
State population. The annual credit allocation per State for 2003 is
$1.75 per resident or $2.03 million in total, if larger.
Effect of Provision
Comprehensive data from tax returns concerning the low-
income housing tax credit are unavailable. Table 13-17 presents data
from a survey of State credit allocating agencies. These data indicate
that annual allocation of available credit authority generally has
been 90 percent or greater since 1994. Year-to-year variations in
credit allocation probably reflect changes in Federal law affecting
the credit and changing economic conditions affecting the construction
and housing markets. For example, 1990 was the first year following
substantial modification to the credit and included a temporary
period during which State credit allocating agencies were limited
to allocating authority of $0.9375 per capita rather than the
$1.25 per capita of present and prior law.
An allocation percentage of less than 100 percent does not
imply that some credits available for allocation to low-income
housing projects go unused. Since 1990, States are permitted to carry
forward unused credit subsequently made available for allocation by
other States. Thus, the amount allocated in any one year could be
less than the States' authority, but such authority may ultimately
be allocated.
TABLE 13-17 -- ALLOCATION OF THE LOW-INCOME HOUSING CREDIT, 1987-2000
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TAX CREDIT AND EXCLUSION FOR ADOPTION EXPENSES
The Small Business Job Protection Act of 1996 (Public Law 104-188)
enacted two tax provisions designed to reduce economic barriers to
adoption. First, a tax credit of up to $5,000 (or $6,000 in the case
of families adopting special-needs children from the United States)
was created to help defray one-time adoption expenses (Code
section 23). The credit was phased out for families with incomes
above $75,000, and was unavailable to families with incomes above
$115,000. Second, employees could receive an income tax exclusion of
up to $5,000 per child (or $6,000 in the case of special-needs
children) for employer-provided adoption assistance (Code
section 137). Under the Act, the credit (other than for foreign
special-needs adoptions) and the exclusion were not available after
December 31, 2001.
EGTRRA and the Job Creation and Worker's Assistance Act of
2002 ("JCWAA") made several changes to these provisions. EGTRRA,
as clarified by JCWWA: (1) made permanent the adoption credit and
exclusion for employer-provided assistance; (2) increased the maximum
credit and exclusion amounts to $10,000; (3) provided that the
maximum credit and exclusion amounts for special-needs adoption
expenses are available regardless of whether the taxpayer has
qualified adoption expenses (effective after 2002); and (4) increased
the beginning and end points of the income phase out ranges to
$150,000 and $190,000, respectively, for both the credit and the
exclusion. EGTTRA also provided that the dollar limits and the
income limitations of the credit and the exclusion are adjusted for
inflation in taxable years beginning after December 31, 2002. For
2003, the maximum credit and exclusion amounts are $10,160 and the
beginning and end points of the income phase out ranges are $152,390
and $192,390, respectively.
CHILD TAX CREDIT
The Taxpayer Relief Act of 1997 provided for a $500 ($400 for
taxable year 1998) tax credit for each qualifying child under the age
of 17. A qualifying child is defined as an individual for whom the
taxpayer can claim a dependency exemption and who is a son or
daughter of the taxpayer (or a descendant of either), a stepson or
stepdaughter of the taxpayer, or an eligible foster child of the
taxpayer. For taxpayers with modified AGI in excess of certain
thresholds, the allowable child credit is phased out.
EGTRRA increased the child credit on a phased in basis,
reaching $1,000 in 2011, and provided for limited refundability of
the credit. JCWAA accelerated this increase in the credit to $1,000,
effective for 2003 and 2004, and expanded the refundability of the
credit.
The child credit is refundable to the extent of 10 percent
of the taxpayer's earned income in excess of $10,500 (indexed for
inflation) in 2003. This percentage is increased to 15 percent for
calendar year 2005 and thereafter. Families with three or more
children are allowed a refundable credit for the amount by which the
taxpayer's Social Security taxes exceed the taxpayer's earned income
credit, if that amount is greater than the refundable credit based
on the taxpayer's earned income in excess of $10,500.
For taxpayers with modified AGI in excess of certain
thresholds, the child credit is phased out. The phase out rate is $50
for each $1,000 of modified AGI (or fraction thereof) in excess of the
threshold. For these purposes modified AGI is computed by increasing
the taxpayer's AGI by the amount otherwise excluded under Code
sections 911, 931, and 933 (relating to the exclusion of income of
U.S. citizens or residents living abroad; residents of Guam, American
Samoa, and the Northern Mariana Islands; and residents of Puerto Rico,
respectively).
For married taxpayers filing joint returns, the threshold is
$110,000. For taxpayers filing single or head of household returns,
the threshold is $75,000. For married taxpayers filing separate
returns, the threshold is $55,000. These thresholds are not indexed
for inflation.
EFFECT OF TAX PROVISIONS ON THE INCOME AND TAXES OF
THE ELDERLY AND THE POOR
Tables 13-18 and 13-19 present actual and projected values of
the personal exemptions, standard deductions, additional standard
deductions for the elderly and the blind, and taxable income brackets
for 1996-2013. The figures for 2004-13 are based on Congressional
Budget Office projections. The value to taxpayers of personal
exemptions, standard deductions, and additional standard deductions
for the elderly and the blind (with the exception of joint filers
after 2010) will grow steadily over the 10-year period.
HYPOTHETICAL TAX CALCULATIONS FOR SELECTED FAMILIES
Table 13-20 presents examples of tax liabilities for
hypothetical taxpayers. The table presents 2003 Federal income and
payroll tax burdens. The worker is assumed to bear both the employer
and employee shares of FICA tax (7.65 percent for each). Taxpayers
claim the EIC, if eligible, and they claim the standard deduction,
except where noted in the footnotes. Income sources are listed in the
table's footnotes for each example.
TAX TREATMENT OF THE ELDERLY
Present law contains several provisions that reduce, or in
some cases eliminate, the burden of Federal income tax on senior
citizens. These provisions are: the exemption from income taxation of
some or all of an individual's Social Security benefits; a tax credit
for certain taxpayers who do not receive substantial Social Security
income; and an additional standard deduction for taxpayers age 65 and
older. These are described in detail in preceding portions of this
section.
As a result of these favorable tax provisions, the tax
threshold (the level of income, excluding Social Security, at which
tax liability is incurred) for elderly taxpayers is very close to or
above the poverty level. For example, in 2002, a single elderly
individual with $5,000 in Social Security benefits can have up to
$8,850 in other income without incurring tax liability (or total
income of $13,850). An elderly married couple filing jointly with
$5,000 in excluded Social Security benefits has a tax threshold of
$15,650 (or total income of $20,650). By comparison, the poverty
thresholds in 2002 for a single elderly person and an elderly couple
were $8,628 and $10,874, respectively. Table 13-21 displays similar
information for other years and for varying amounts of Social
Security benefits.
The combination of these tax provisions means that an
estimated 50 percent of elderly individuals will have no tax
liability, applying 2003 tax law to 2000 population and income data
(Table 13-22).
TABLE 13-18 -- ACTUAL PERSONAL EXEMPTIONS, STANDARD DEDUCTIONS,
AND TAXABLE INCOME LEVELS, 1996-2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-19 -- PROJECTED PERSONAL EXEMPTIONS, STANDARD DEDUCTIONS,
AND TAXABLE INCOME LEVELS, 2004-2013
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-20 -- EXAMPLES OF FEDERAL INCOME AND PAYROLL TAX LIABILITIES
OF HYPOTHETICAL TAXPAYERS, 2003
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-21 -- INCOME TAX THRESHOLDS FOR ELDERLY INDIVIDUALS, 1996-2003
(ACTUAL) AND 2004-2013 (PROJECTED)
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-22 -- TAX FILING UNITS CLASSIFIED BY MARGINAL FEDERAL INCOME
TAX RATE,1 2003 TAX LAW (2000 POPULATION AND INCOME)
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
Table 13-23 is a more comprehensive version of Table 13-22.
It illustrates for various types of wage earners the additional
(marginal) Federal tax these wage earners will pay if they earn one
more dollar of wages. For purposes of this table, marginal tax rates
include both Federal income and payroll taxes. The majority of
single wage earners have income below $30,000 per year and face
marginal tax rates of 20.0-24.9 percent. In addition, the phaseout of
certain deductions or exclusions under the Code (e.g., the personal
exemption phaseout) and the overall limitation on itemized deductions
also have the effect of imposing additional dollars of tax liability
on a taxpayer as the taxpayer's income increases. Hence, effective
marginal tax rates can exceed the sum of the statutory individual
income tax rate and payroll tax rate.
FEDERAL TAX TREATMENT OF FAMILIES IN POVERTY
During the 1970s and early 1980s, inflation gradually
increased the tax burdens of the poor and lowered the real income
level at which a poor family became liable for income taxation.
Legislation passed by Congress reversed or slowed this trend, but in
the absence of indexing, inflation during this period gradually offset
these legislative efforts. One measure of this trend is the degree to
which the income at which a poor family begins to pay income taxes
(termed the tax threshold, or the tax entry point) exceeds or falls
below the poverty threshold. A second measure is the actual amount
of tax liability incurred by a family with income at the poverty
line.
Table 13-24 shows the income tax threshold, the poverty level,
and the tax threshold as a percent of the poverty level for a married
couple with two children in selected years. These figures demonstrate
that before 1975 a family of four was generally liable for Federal
income tax if the family's income was significantly below the poverty
line. In 1975, following the enactment of the earned income credit
(EIC), a family of four incurred no tax liability until its income
exceeded the poverty threshold by 22 percent. Over the next decade
this margin eroded; by 1984, a poor family of four incurred income
tax liability when its income was 17 percent below the poverty line.
By 1993, changes in the tax law resulted in no tax liability for a
typical family of four until its income exceeded the poverty
threshold by nearly 30 percent.
Table 13-25 shows the income tax burden and payroll tax
burden of households with incomes at the poverty line for families of
different sizes. As a result of the refundable EIC, the table
reflects that many individuals receive a substantial credit that
more than offsets total income, and in many cases Social Security,
taxes paid.
TABLE 13-23 -- DISTRIBUTION OF EARNERS BY INCOME AND MARGINAL TAX
RATES ON WAGES, 2003 TAX LAW (2000 POPULATIONS AND INCOMES)
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-24 -- RELATIONSHIP BETWEEN INCOME TAX THRESHOLD AND POVERTY
LEVEL FOR A FAMILY OF FOUR, SELECTED YEARS 1959-2013
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
TABLE 13-25 -- TAX THRESHOLDS, POVERTY LEVELS, AND FEDERAL TAX
AMOUNTS FOR DIFFERENT FAMILY SIZES WITH EARNINGS EQUAL TO THE
POVERTY LEVEL, 1995-2012
[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]
REFERENCES
Committee on Ways and Means. (1998). Green Book.
Washington, DC: U.S. Government Printing Office.
Congressional Budget Office. (1997, January). Economic and
budget outlook: Fiscal years 1998-2007. Washington, DC: Author.
Congressional Research Service. (1999, October 6). Health
insurance coverage: Characteristics of the insured and
uninsured populations in 1998 (96-891 EPW).
Washington, DC: Author.
Federal Register. (2000, February 15). 65(31), 7555-57.
Internal Revenue Service. (various years). Internal revenue
bulletin. Washington, DC: U.S. Government Printing Office.
Internal Revenue Service. (1999, November 15). Internal
revenue bulletin. Washington, DC: U.S. Government
Printing Office.
Internal Revenue Service. (various years). Statistics of
Income. Washington, DC: Author.
Joint Committee on Taxation, U.S. Congress. (1999). Estimates
of Federal tax expenditures for fiscal years 2000-2004
(JCS-13- 99). Washington, DC: U.S. Government Printing Office.
Mills, E.S. (1987, March-April). Dividing up the investment
pie: Have we overinvested in housing? Philadelphia Business
Review, pp. 13-23.
National Council of State Housing Agencies. (1996). State HSA
fact book: 1996 NCSHA annual survey results. Washington, DC:
Author.
Scholes, M., & Wolfson, M. (1992). Taxes and business
strategy: A planning approach. New York: Prentice-Hall.
Social Security Administration. (1996). Black lung benefits
program highlights. Annual Statistical Supplement to the
Social Security Bulletin. Washington, DC: Author.
Turner, J.A., & Beller, D. (1989). Trends in pensions.
Washington, DC: U.S. Department of Labor.
U.S. Bureau of Labor Statistics. (1993). Employee benefits in
medium and large private establishments. Washington, DC:
Department of Labor.
U.S. Bureau of Labor Statistics. (1996). Employee benefits in
small private establishments. Washington, DC: Department of
Labor.
U.S. Census Bureau. (1999). Statistical abstract of the
United States (119th Ed.). Washington, DC: U.S. Government
Printing Office.
U.S. Department of Labor. (1989, January). Annual report on
administration of black lung benefits during calendar year
1986. Washington, DC: Author.
U.S. Department of Labor. (1994). Pension and health benefits
of American workers: New findings from the April 1993 current
population survey. Washington, DC: Author.
Woods, J.R. (1989). Pension coverage among private wage and
salary workers: Preliminary findings from the 1988 survey of
employee benefits. Social Security Bulletin, 52(10), 2-19.
This applies to pension contributions made by employers.
Employees may also be able to contribute to qualified plans. Employee
contributions may be made with aftertax dollars. If so, the tax
advantage given to these contributions is smaller than the tax-
advantage given to employer contributions, and consists of the
deferral of tax on accumulated earnings.
The provisions of EGTTRA generally do not apply for years
beginning after December 31, 2010. See Internal Revenue Service,
Internal Revenue Bulletin, 1938-1, Income Tax Unit 3154, p. 114;
1938-2, Income Tax Unit 3229, p. 136; and 1941-1, Income Tax
Unit 3447, p. 191.
To the extent the employer bears a portion of the payroll
tax, the employer may actually prefer to provide compensation through
health insurance (which is not subject to payroll tax).