Two of the lesser known and least understood provisions of the
fiscal cliff legislation will
raise taxes on high-income taxpayers by phasing out personal exemptions
and the amount of itemized deductions wealthy taxpayers are allowed in
2013.
The set of rules, dubbed personal exemption phase-out (PEP) and Pease
(named after former Congressman Donald Pease, who helped create it),
were originally passed in the early 1990s, and remained in place until
the Bush-era tax cuts of 2001 gradually eliminated them. The new fiscal
cliff bill restores the limitations in 2013*. By limiting the number of
exemptions and deductions a high-income taxpayer is allowed, the taxes
effectively raise a filer’s taxable income.
RELATED: Who Pays More Under the Fiscal Cliff Deal?
The fiscal cliff deal raised federal income taxes on married
households who earn more than $450,000, or single filers who earn more
than $400,000, but the new PEP and Pease limits on the value of personal
exemptions and itemized deductions apply for married taxpayers who earn
$300,000 or $250,000 for single filers.
“It’s a sneaky rate increase once you get above the thresholds,” says Matthew LePley, a tax manager at Brighton Jones LLC.
While taxpayers will not have to deal with the tax changes this
filing season, experts recommend planning ahead, as a number of
tax-saving strategies can be put into action now.
PEP
Beginning in 2013, the personal exemption
phaseout limits the value of personal exemptions for taxpayers who earn
more than $300,000 (married filing jointly), or $250,000 (single) by 2
percent for each $2,500 earned above the thresholds.
The personal exemption, or the amount of income the IRS designates as
“exempt” from being taxed at the federal level, is indexed for
inflation, so the personal exemption amount is $3,800 for 2012, and
rises to $3,900 in 2013.
On their 2013 tax return, for example, a married couple with two
children earning $425,000, or $125,000 over the threshold, would lose
100 percent of their personal deductions ($125,000/$2,500 = 50 and
50x.02 = 1, for a 100 percent loss). Assuming one spouse doesn’t work,
the household would lose all four personal exemptions of $3,900 per
person, adding up to a $15,600 increase in taxable income for the 2013
tax year.
Using that same scenario, a family of four who earns $375,000, or
$75,000 over the threshold, would lose only 60 percent of their
allowable personal exemptions, or $9,360, leaving the family with a
deduction of $6,240.
“If you make that kind of money, you will not be allowed to take all
of your itemized deductions and your personal exemptions also will be
reduced,” said Harvey Frutkin, senior counsel at Frutkin Law Firm Pc.
“The impact will be pretty significant.”
PEASE
For the 2013 tax year, the Pease
Limitations cap deductions on everything from state taxes to mortgage
interest to charitable deductions for tax filers who earn more than
$250,000 (single) or $300,000 (married, filing jointly). A recent
JPMorgan Chase & Co. note to clients estimated this rule will result
in a tax hike of about 1.2 percent for taxpayers who live in states
with high income taxes.
The restored limits reduce allowable deductions and can by calculated
two ways: (1) 3 percent of adjusted gross income above the threshold,
or (2) 80 percent of the amount of the itemized deductions allowable for
the taxable year – whichever calculation lets a taxpayer deduct a
higher amount is the one they’ll want to use. For most high-income
earners, the 3 percent calculation gives them the highest deduction.
For example, assume a married couple has an adjusted gross income of
$500,000 ($200,000 over the limit) and total itemized deductions of
$45,000. The deductions are broken down as follows:
Mortgage interest deduction: $10,000
Charitable deduction: $20,000
State income tax deduction: $10,000
Property tax deduction: $5,000
By using the three percent deduction calculation (3% x 200,000), the
couple’s itemized deductions would be reduced by $6,000, leaving a total
deduction of $39,000.
On the other hand, using the calculation of 80 percent of the total
itemized deductions would reduce the couple’s itemized deductions by
$36,000, leaving a deduction of only $9,000.
Since the first option is the lesser of the two limitations, the
couple’s deductions would be reduced to $39,000, rather than $45,000.
HOW TO PREPARE
To lessen the pain, LePley says
most high-income taxpayers will want to maximize tax deductions,
including charitable donations, but warns that both the PEP and Pease
limitations are difficult to avoid, and should be considered with a
comprehensive wealth management strategy.
Shauna Wekherlien, owner of Tax Goddess Business Services Pc, says
high income taxpayers may want to bundle medical expenses in 2013
because they must exceed 10 percent of adjusted gross income to qualify.
“
Taxpayers
that are considering elective medical procedures will want try to
schedule them all in one year to maximize the value of the deductions,”
she said.
LePley suggests that high-income households consider taking advantage
of the federal estate and gift tax exemption of up to $5.25 million
over a lifetime. Taxpayers who used the full exemption in 2012 still
have another $130,000 to gift tax-free this year due to inflation
adjustments.
A recent JPMorgan Chase & Co. paper from a team of wealth
advisors and investment specialists recommends that wealthy taxpayers
who own several homes also may want to consider switching their main
domicile to the home in the state with the lowest state income tax
burden.
The report also suggests tax-advantaged investment strategies such as
purchasing tax-exempt municipal bonds, annuities and life insurance
policies.
“There are certainly esoteric investments out there such as
structured notes and private equity, but those tend to be fraught with
risk,” says Karen Kruse, president of First Tennessee Advisory services.
Kruse said dividend-paying stocks and solid blue chips should be held
in a tax-advantaged account, such as an IRA. “Outside of your
tax-exempt accounts, you would tend to go towards growth-oriented stocks
that typically don’t throw off income,” she said. “You buy and hold
them, and your gains become long-term gains.”
She is not advising clients to invest in long-term bonds: “You might
want to invest in municipal bonds, but you’d really want to stay short,”
she said. “I think the market is waiting for the first sign of
inflation,” Kruse recommends investing in assets that will rise with
inflation such as real estate investment trusts, real estate, utilities
and commodities.
According to LePley, retirees will be in the best position to save,
since they have more flexibility with their annual distributions. “Most
working people are not going to be able to manage what they make,” he
said. “But, for retirees, that’s where we can manage a little better.”
Taxpayers over the age of 70.5 can also rollover up to $100,000 per
year from individual retirement accounts to qualified charities in 2012
and 2013 only. These rollovers meet both
minimum distribution requirements and limit taxable income.
A QUICK GUIDE TO DEDUCTIONSThe big three:
- Charitable deductions : Contributions
to charitable organizations may be deducted up to 50 percent of
adjusted gross income. Contributions to certain private foundations,
veterans organizations, fraternal societies, and cemetery organizations
are limited to 30 percent adjusted gross income.
- Mortgage interest :
Any interest on a mortgage is deductible, but filers can’t deduct
interest on mortgages that exceed $1 million. If you have a second loan
or a home equity line of credit, the filer can only deduct interest on
loans up to $100,000.
- State, local and property taxes :
There are a handful of states with no state income tax, but for filers
in high-income tax states, this deduction prevents residents from being
taxed twice.
Other misc. deductions:
- Gambling: Gambling winnings are fully taxable and
must be reported on a tax return, however taxpayers can limit the amount
of winnings taxed by deducting their gambling losses.
- Investment and advisory fees: Certain investment management and advisory fees also are deductible.
- Alimony: All payments that qualify as alimony are
also deductible under the U.S. tax code. However, child support, noncash
property settlements, and use of a filer’s property do not qualify.
- Job-related moving expenses: If you moved due to a
new job, you may be able to deduct your moving expenses. The new
workplace must be at least 50 miles farther from your old home and the
job must be full-time.
*While the 2013 tax changes are said to be “permanent” and not
set to expire, there are many fiscal and tax issues still being
discussed in Congress, and future amendments could be made to the tax
code. Be sure to consult your accountant or tax professional to discuss
your wealth and tax strategies.
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