You’ll Have to Hang On Until 2010 to Catch the Full Estate Tax Repeal

Question: We heard that Congress is gradually phasing out estate taxes. Has the exemption--the amount that can be passed to heirs free of tax--been increased for 2001? And have the tax rates for this and future years been changed?

Answer: Gradual estate tax repeal was included in the $1.35-trillion tax-cut bill Congress approved over Memorial Day weekend. But the changes don’t start until next year--and they have a limited life span.

The amount that can be passed tax-free to heirs rises to $1 million next year from $675,000 this year. In 2004, the exemption limit is scheduled to increase to $1.5 million, and in 2006 it’s supposed to go to $2 million. In 2009--the year before total repeal is scheduled to take effect--the limit is scheduled to rise to $3.5 million.

Meanwhile, the estate tax rates will be lowered. The top rate, now 55%, goes to 50% next year, then drops 1 percentage point each year until it reaches 45% in 2007, where it will stay until repeal in 2010.

The higher exemption limits will eliminate the tax for many people. But the relief may be short-lived.

As it stands now, estate taxes will be fully repealed for just one year--2010--before the repeal “sunsets” and the old estate tax rules come back into effect. That means that in 2011, the top rate would return to 55% and the exemption amount would revert to $1 million. (Under current law, the exemption limit would have been $1 million by 2006.)

Confusing and complicated? Oh, yes. And it may get worse. Many foes of estate tax repeal say the changes are too expensive and they vow to undo some or all of what’s been done.

What that means is that if you have a large estate, you’ll need to keep track of the battles and be ready to change your estate plans as needed.

Income Definitions Key to Roth IRA Eligibility

Question: I contributed to a Roth IRA in 1998, but later undid the transaction when I learned that my 1998 income was over the $95,000 limit for a single person.

Recently, I read in a personal finance magazine that in order to establish a Roth, one must receive taxable earned income and that income cannot include disability payments, earnings and profits on investments or property, interest, dividends, pension and annuity payments, or deferred incentive awards like stock options. If I had not included dividends, capital gains and interest, I would not have exceeded the income cap.

It seems to me that I did not have to recharacterize and that my original contribution was fine. What do you think?

Answer: You did the right thing by undoing the original transaction. To understand why, you need to understand some of the different ways the IRS defines and treats income. The two key definitions in this case are “earned income” and “modified adjusted gross income.”

The Roth IRA was designed to allow working stiffs to put aside money that would be tax-free in retirement. The emphasis here is on “working”--it’s not a device for folks rolling in dividends and interest payments to shelter money from taxation.

So to contribute to a Roth, you have to earn taxable income in the form of wages, salary, tips, business income, commissions and professional fees. Alimony also is included in this list of what qualifies as “earned” income--which is sure to annoy some alimony payers but please the alimony receivers.

Congress decided to further limit who gets to contribute to a Roth by excluding higher-income taxpayers, even if they work for a living.

For single people, the ability to contribute to a Roth begins to phase out when modified adjusted gross income reaches $95,000, and for married couples filing jointly the phase-out begins at $150,000. The ability to contribute ends when income exceeds $110,000 for singles or $160,000 for those who are married.

Modified adjusted gross income includes most types of income, including the types excluded from the definition of earned income. That’s why your dividends, capital gains and interest are counted as part of the income limit.

That might not make you feel any better about your inability to contribute, but at least you now know why.

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Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at moneytalk@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012. She regrets that she cannot respond personally to queries. For past Money Talk questions and answers, visit The Times’ Web site at https://www.latimes.com/moneytalk.