Fiscal Cliff Law and Exemption and Deduction Phaseouts

The previous two posts about the fiscal cliff law looked at Roth conversion and dividends and capital gains. Today we look at the new law’s reductions to personal exemptions and deductions for higher income taxpayers.

Higher income for this purpose is defined as having Adjusted Gross Income (AGI) in 2013 over $250k for single and $300k for married filing jointly. These income thresholds are adjusted to inflation in future years. If your AGI is below this level, fortunately or unfortunately your exemptions and deductions are not affected by the new law.

For those affected, congratulations for making a good income. You’d rather have the higher income and give up some exemptions and deductions than not having the income. There’s also a piece of good news at the end of this article. So hang on.

Personal Exemption Phaseout

For each person on the tax return — you, spouse, and your dependents — you get a personal exemption. It’s $3,900 per person in 2013. Exemption works pretty much like a deduction. Your income is reduced by the exemption before applying the tax schedule.

If your income is above $250k/$300k, for each $2,500 above that level (and the last fraction of $2,500), you lose 2% of the personal exemption. If you earn extra $2,500 in income, you will lose this much in exemptions:

$3,900 * number of exemptions * 2% = $78 * number of exemptions

At a 33% marginal tax rate, it means extra ($26 * number of exemptions) in taxes for each extra $2,500 in income. That’s about an extra 1% in marginal tax rate for each person on your tax return. For the proverbial family of four, add 4% to the marginal tax rate.

Because the maximum you can lose is 100%, the extra marginal rate stops after your AGI exceeds $2,500 * 50 = $125,000 above the threshold, namely $375k for single and $425k for married filing jointly. Once your AGI reaches $375k/$425k, you’ve already lost 100% of your personal exemptions. There’s no more to lose. Your marginal rate drops back down to "normal."

Limitation On Itemized Deductions

Your misery doesn’t end with the personal exemption phaseout. Your itemized deductions are also reduced by 3% of the amount you make above the $250k/$300k threshold. If you make $400k when you are married filing jointly, your itemized deductions are taken away by

($400k – $300k) * 3% = $3,000

Losing $3,000 in deductions means an extra $1,000 in tax for an extra $100k income above the threshold. So that’s another 1% in marginal tax rate on the extra income.

There’s a special rule that your itemized deductions can’t be take away by more than 80% because of this.

Note that the reduction is calculated off your income. Deductions beyond the reduction is still worth the full amount. For example suppose your itemized deduction before the reduction is $20,000 and this new law reduces by $3,000 to $17,000. If you donate another $5,000 to charity, the reduction is still the same $3,000 because your income didn’t change. Your deductions will increase by the full $5,000, from $20,000 – $3,000 = $17,000 to $25,000 – $3,000 = $22,000. You are still getting the full credit for your donation.

Absorbed by AMT

This is the good news I referred to in the opening paragraph. All these fancy math only affects the "regular" tax. When you pay AMT, you don’t get personal exemptions anyway. Most of your itemized deductions also don’t count except basically mortgage interest and charitable donations. They are not subject to further reduction under AMT.

In the end when you are deep into AMT, your regular tax goes up because the phaseout and limitation, your AMT goes down, and your bottom line stays unchanged!

Everyone says AMT is complicated. It’s actually much simpler.