Two Hidden Taxes
(Reinstatement of Itemized Deduction and Exemption Phase-outs)
By Natalie Solotoff, Tax Senior Manager
Sometimes tax increases are not as straightforward as increased tax rates. In addition to raising tax rates on the wealthiest individuals from 35% to 39.6% and implementing a 3.8% surtax on passive income for individuals with adjusted gross income over $200,000 ($250,000 for joint filers), The American Taxpayer Relief Act of 2012 (the “Act”) included two less frequently discussed provisions that will also increase taxes on certain individuals. These provisions reduce tax savings from personal exemptions and itemized deductions for taxpayers with adjusted gross income over yet another threshold level ($250,000 for single filers and $300,000 for joint filers).
The Personal Exemptions Phase-Out
The Personal Exemptions Phase-Out (PEP) is an old rule that was reinstituted by the Act, but with higher applicable income thresholds than previously in place. The new thresholds are as follows:
- $300,000 Joint
- $275,000 Head of household
- $250,000 Single
- $150,000 Married filing separately
In 2013, a taxpayer is allowed a $3,900 exemption for herself, her spouse, and each dependent claimed on her return. Under the PEP, the total amount of exemptions allowed is reduced by two percent for each $2,500 by which a taxpayer’s adjusted gross income exceeds the applicable threshold.
As an example, a taxpayer filing a joint return with two dependents normally would be allowed a $15,600 exemption ($3,900 * 4). Under the PEP, however, assuming the taxpayer’s adjusted gross income is $400,000, the allowable exemption is reduced from $15,600 to $3,120. Assuming the 35% tax rate applies, the increased federal tax associated with the phase-out in this scenario amounts to almost $4,400 ($12,480 * 35% = $4,368).
The Pease Limitation
The limitation to itemized deductions imposed by the Act is also the reinstitution of an old rule. The provision is often called the Pease limitation for the late Congressman, Donald J. Pease, from Ohio, who conceived the idea back in the early-1990s. The Pease limitation reduces the total amount of allowable itemized deductions by three percent of the amount by which the taxpayer’s adjusted gross income exceeds the applicable threshold, but cannot reduce the total itemized deductions by more than 80 percent overall. The same threshold amounts apply to the Pease limitation as apply to the PEP.
For a taxpayer filing a joint return with adjusted gross income of $400,000 and $50,000 of itemized deductions, the tax impact would be an increase of approximately $1,000. The allowable deductions under the Pease limitation are reduced from $50,000 to $47,000 ($100,000 excess AGI * 3% = $3,000 reduction in allowable deductions), thus the tax savings disallowed by the limitation in this scenario amounts to just over $1,000 ($3,000 * 35% = $1,050).
The Pease limitation does not apply to all itemized deduction. It excludes medical expenses, investment interest expenses, casualty and theft losses and gambling losses. The medical expense deduction and investment interest expense deduction, however, have been and are subject to other limitations. Perhaps of particular interest, the Pease limitation does apply to the deduction for charitable donations, which has worried some commentators. The concern is that the Pease limitation will dampen charitable giving, although the impact on charitable giving remains to be seen. In fact, at least one author has asserted that charitable giving increased over the period from 1990 to 2005 when the Pease limitation was previously in effect. Proponents of the new legislation say that because the limitation is based on adjusted gross income levels and not the amount of charitable donations, it will not affect taxpayer’s decisions about how much to give to charity.
In the end, the result of both the PEP and the Pease limitation is an increased tax burden on certain individuals who have adjusted gross income over at least $250,000 ($150,000 married filing separately) and who, in the past, would have benefitted from multiple exemptions and/or higher itemized deductions (i.e., individuals with more than one dependent, high property taxes or state income taxes, or who give generously to charity). For those individuals most affected, there are some tax-planning opportunities for avoiding the brunt of the increased tax burden. For instance, if the taxpayer has some flexibility over the amount of income she recognizes in a given year, the goal would be to remain below the applicable adjusted gross income thresholds. Similarly, projecting income over several years and spreading deductions over multiple years could help by avoiding steep limitations in a given year.
If you have any questions, please contact Natalie Solotoff or your BNN tax advisor.
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