High-Earners Affected By New Tax Phase-Outs

Barry Lasik for the Cheif Leader writes: The American Taxpayer Relief Act of 2012 included a provision to phase out, beginning in 2013, both personal exemptions and itemized deductions for higher-income taxpayers. The phase-out will begin when a taxpayer’s adjusted gross income (AGI) reaches a phase-out threshold amount.

The exemption phase-out starts once AGI exceeds $250,000 (single) and $300,000 (married filing jointly). If your AGI falls below these thresholds, this provision has no effect on your taxes. The personal-exemption amount is $3,900 for the 2013 tax year. The phase-out of the personal exemption (sometimes called “PEP”) means for every $2,500 of AGI (or portion of) over these thresholds, personal exemptions are reduced by 2-percent. For single filers, personal exemptions will be fully phased out once their AGI exceeds $372,501; for married couples, once AGI exceeds $422,501.

As mentioned, the exemption amount is $3,900, so each phase-out increment wipes out ($3,900 x 2-percent) or $78 of your deduction, increasing your taxable income by that amount. A family of five would see $390 in deductions disappear with each increment.

Barry and Carol, for example, have an AGI of $412,500 for 2013 and two children for a total of four exemptions totaling $15,600 (4 x $3,900). The threshold for a married couple is $300,000; thus their income exceeds the threshold by $112,500. Dividing that sum by $2,500 equals 45. So (45 x 2-percent) of their $15,600 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,560. Assuming Barry and Carol are in the 33-percent Federal tax bracket, the phase-out costs them an additional $4,633 ($15,600 x 90-percent x 33-percent).

Using the same scenario, a family of four that earns $375,000, or $75,000 over the threshold, would lose only 60 percent of its allowable personal exemptions, or $9,360; leaving the family with a deduction of $6,240.

The phase-out of itemized deductions (often called the “Pease”) will also raise tax bills for high-income earners by reducing the tax benefit of the certain itemized deductions. These deductions include: mortgage interest; property, income and sales taxes; contributions; and miscellaneous deductions.

The total amount of itemized deductions is reduced by 3-percent of the amount by which the taxpayer’s AGI exceeds the threshold amount, with the reduction not to exceed 80-percent of the allowable itemized deductions.

Barry and Carol from the previous example, who had an AGI of $412,500 for 2013, exceed the threshold for a married couple by $112,500. Their itemized deductions total $24,000. Thus, they must reduce their itemized deductions by $3,375 (3-percent of $112,500), but the reduction must not exceed 80-percent of the deductions. The phase-out is the lesser of $3,375 or $4,800, which is 80 percent of $24,000, or$19,200. Assuming Barry and Carol are in the 33-percent Federal tax bracket, the phase-out will cost them an additional $1,114 ($3,375 x 33-percent).

Taxpayers impacted by these phase-outs would be wise to review potential tax liabilities early in the 2013 tax year to possibly adjust estimated taxes or withholding amounts.