How the New Tax Law Screws the Upper Middle Class
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How the New Tax Law Screws the Upper Middle Class

iStockphoto/The Fiscal Times

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.

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.”

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.

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.

The 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.