Tax Attorneys at Ainer & Fraker, LLP Discuss Tax Planning Strategies for Minimizing the Tax Bite from Exemption & Itemized Deduction Phase-outs:
Generally, taxpayers are allowed to deduct personal exemptions of $3,900 for themselves, their spouses and their dependents. In addition, taxpayers are allowed a standard deduction or, if their deductions are large, they can itemize their deductions.
The American Taxpayer Relief Act of 2012 included a provision to phase out, beginning in 2013, both the 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 threshold amounts are based on the taxpayers’ filing statuses and are: $250,000 for single filers, $275,000 for individuals filing as heads of households, $300,000 for married couples filing jointly and $150,000 for married individuals filing separately. Here is how the phase-out will work:
- Personal Exemption—The otherwise allowable exemption amounts are reduced by 2% for each $2,500 or part of $2,500 ($1,250 for a married taxpayer filing separately) that the taxpayer’s AGI exceeds the threshold amount for the taxpayer’s filing status.
Example: Ralph and Louise have an AGI of $412,500 for 2013 and two children for a total of four exemptions totaling $15,600 (4 × $3,900). The threshold for a married couple is $300,000; thus, their income exceeds the threshold by $112,500. Dividing $112,500 by $2,500 equals 45. So 90% (45 × 2%) of their $15,600 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,560 ((100–90) × $15,600). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $4,633 ($15,600 × 90% × 33%).
Divorced or separated parents subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent. Where a taxpayer is a party to a multiple support agreement, the taxpayer may want to allow another contributing member of the agreement who is not hit by the phase-out to claim the dependent’s exemption.
- Itemized Deductions—The total amount of itemized deductions is reduced by 3% of the amount by which the taxpayer’s AGI exceeds the threshold amount, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.
Not all itemized deductions are subject to phase-out. The following deductions are not subject to the phase-out:
- Medical and dental expenses
- Investment interest expenses
- Casualty and theft losses from personal-use property
- Casualty and theft losses from income-producing property
- Gambling losses
Thus, a taxpayer who is subject to the full phase-out still gets to deduct 20% of the deductions subject to the phase-out and 100% of the deductions listed above.
Example: Ralph and Louise from the previous example, who had an AGI of $412,500 for 2013, exceed the threshold for a married couple by $112,500. Thus, they must reduce their itemized deductions subject to the phase-out by $3,375 (3% of $112,500), but the reduction must not exceed 80% of the deductions subject to the phase-out. For 2013, Ralph and Louise had the following itemized deductions:
Subject to Phase-out Not Subject to Phase-out
Home mortgage interest: $10,000
Charitable contributions: $6,000
Casualty loss: $12,000
Total: $24,000 $12,000
The phase-out is the lesser of $3,375 or 80% of $24,000. Thus Ralph and Louise’s itemized deductions for 2013 will be $32,625 ($24,000 – $3,375 + $12,000). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out will cost them an additional $1,114 ($3,375 × 33%).
Conventional thinking is to maximize deductions. However, where taxpayers normally are not subject to a phase-out and have a high-income year because of unusual income, it may be appropriate, where possible, to defer paying deductible expenses to the year following the high-income year or perhaps pay and deduct the expenses in the preceding year.
Please Contact a Tax Attorney at Ainer & Fraker, LLP if you have questions about how these phase-outs will impact your specific situation, you want to adjust your withholding or estimated taxes, or you want to make a tax planning appointment