In less than six months, unless Congress acts, the individual marginal income tax rate reductions under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will expire. While the timetable for addressing the EGTRRA tax cuts is not certain, the approaching sunset of the individual rate reductions, the possibility for their extension, and the fate of the limit on itemized deductions and the personal exemption phase-out will touch all taxpayers. The potential rate change makes tax planning all the more important.

Individual income tax rates

EGTRRA set in motion a gradual reduction of the individual marginal income tax rates. EGTRRA also created a new and temporary 10 percent regular income tax bracket for a portion of taxable income that was previously taxed at 15 percent.

The federal individual income tax rates for 2010 are:

Single individuals: If taxable income is not over $8,375: 10% of the taxable income; Over $8,375 but not over $34,000: $837.50 plus 15% of the excess over $8,375; Over $34,000 but not over $82,400: $4,681.25 plus 25% of the excess over $34,000; Over $82,400 but not over $171,850: $16,781.25 plus 28% of the excess over $82,400; Over $171,850 but not over $373,650: $41,827.25 plus 33% of the excess over $171,850; and Over $373,650: $108,421.25 plus 35% of the excess over $373,650.

Married couples filing a joint return: If taxable income is not over $16,750: 10% of the taxable income; Over $16,750 but not over $68,000: $1,675 plus 15% of the excess over $16,750; Over $68,000 but not over $137,300: $9,362.50 plus 25% of the excess over $68,000; Over $137,300 but not over $209,250: $26,687.50 plus 28% of the excess over $137,300; Over $209,250 but not over $373,650: $46,833.50 plus 33% of the excess over $209,250; and Over $373,650: $101,085.50 plus 35% of the excess over $373,650.

Unless extended or made permanent, the individual marginal income tax rates will all rise after December 31, 2010 when EGTRRA sunsets. The 10 percent regular income tax bracket will also disappear after December 31, 2010 and the first portion of an individual’s taxable income will be taxed at 15 percent rather than at 10 percent.

According to the Joint Committee on Taxation (JCT), after EGTRRA sunsets and with no modification by Congress, the federal individual income tax rates for 2011 will be:

Single individuals: If taxable income is not over $34,850: 15% of the taxable income; Over $34,850 but not over $84,350: $5,227.50 plus 28% of the excess over $34,850; Over $84,350 but not over $176,000: $19,087.50 plus 31% of the excess over $84,350; Over $176,000 but not over $382,650: $47,499 plus 36% of the excess over $176,000; and Over $382,650: $121,893 plus 39.6% of the excess over $382,650

Married couples filing a joint return: If taxable income is not over $58,200: 15% of the taxable income; Over $58,200 but not over $140,600: $8,730 plus 28% of the excess over $58,200; Over $140,600 but not over $214,250: $31,802 plus 31% of the excess over $140,600; Over $214,250 but not over $382,650: $54,633.50 plus 36% of the excess over $214,250; and Over $382,650: $115,257.50 plus 39.6% of the excess over $382,650.

President Obama has asked Congress to permanently extend the current 10, 15, 25, and 28 percent rates. Under the president’s proposal, these rates would continue for individuals without interruption after December 31, 2010. However, the president’s proposal would allow the 33 percent rate bracket and the 35 percent rate brackets to become 36 percent and 39.6 percent, respectively, after December 31, 2010.

The president has also asked Congress to expand the tax rate bracket for the 28 percent rate so that individuals with less than $195,550 of taxable income in 2011 ($200,000 of AGI), assuming one personal exemption and the basic standard deduction, indexed from 2009) will not be subject to the 36 percent rate that applies after December 31, 2010. For married individuals filing joint returns and surviving spouses, the dollar threshold for the 36 percent bracket would be set so that married couples and surviving spouses with AGI below $237,300 of taxable income in 2011 ($250,000 of AGI, assuming two personal exemptions and the basic standard deduction, indexed from 2009), subject to the 33 percent rate in 2010, will not become subject to the 36 percent rate after December 31, 2010.

Capital gains/dividends

At the same time taxpayers are looking at higher individual marginal income tax rates, the capital gains and dividend tax rates will also increase after December 31, 2010. For 2010, the maximum capital gains and dividends tax rate is 15 percent (zero percent for taxpayers in the 10 and 15 percent brackets). Effective January 1, 2011, the tax rate on qualified long-term capital gains will be 20 percent and taxpayers will pay tax on dividends at the same rates that apply to ordinary income.

President Obama has asked Congress to impose a 20 percent capital gains and dividends tax rate on individuals with incomes above $200,000 (less the standard deduction and one personal exemption indexed from 2009). The 20 percent rate would also apply to married couples filing a joint return with income above $250,000 (less the standard deduction and two personal exemptions indexed from 2009). All other taxpayers would pay capital gains and dividends taxes of 15 percent unless they qualify for the zero percent tax rate.

If Congress does not act, the tax rate on dividends after December 31, 2010 will be the same as that currently for dividends failing to qualify for the current 15 percent rate; that is, the same as a taxpayer’s personal income tax bracket.

Limitation on itemized deductions

Along with reducing the individual marginal income tax rates, EGTRRA also repealed the limitation on itemized deductions for 2010, but only for 2010. President Obama has asked Congress to allow the limitation on itemized deductions to return but to modify it for 2011 and beyond. Under the president’s proposal, the limitation on itemized deductions would apply to an AGI threshold determined by taking a 2009 dollar amount and adjusting for subsequent inflation. The Obama administration has proposed a dollar amount of $200,000 for single individuals and $250,000 for married couples filing a joint return.

Also impacting higher-income taxpayers is repeal of the personal exemption phase-out. Under EGTRRA, the personal exemption phase-out is repealed for 2010 – but only for 2010.

What’s next

Congress likely will vote on the administration’s proposal to raise only the top two tax brackets this fall. Whether that vote will come in September or in a lame-duck session after the mid-term elections remains uncertain at this time, as does the outcome of that vote. In the interim, our office will continue to monitor the debate and, as Congress gets closer to a decision, prepare year-end tax strategies that respond most effectively to what Congress decides.