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Higher-Income Taxpayers Subject to Exemption & Itemized Deductions Phase-outs

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On December 22, 2017, The Tax Cuts and Jobs Act was signed into law. The information in this article predates the tax reform legislation and may not apply to tax returns starting in the 2018 tax year. You may wish to speak to your tax advisor about the latest tax law. This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.

Higher-Income Taxpayers Subject to Exemption & Itemized Deductions Phase-outs
Article Highlights:
  • Phase-out Thresholds 
  • Personal Exemption Phase-outs 
  • Itemized Deduction Phase-outs 
Generally, taxpayers are allowed to deduct personal exemption allowances of $4,000 (2015) each for themselves, their spouses and their dependents. In addition, taxpayers are allowed a standard deduction or, if their deductions are large enough, itemized deductions.

However, both the personal exemption allowances and itemized deductions are being phased out for higher-income taxpayers. The phase-out begins when a taxpayer's adjusted gross income (AGI) reaches a phase-out threshold amount that is annually adjusted for inflation.

The phase-out threshold amounts for 2015 are based on taxpayers' filing statuses, and they are: $258,250 for single filers, $284,050 for individuals filing as heads of households, $309,900 for married couples filing jointly and $154,950 for married individuals filing separately. Here is how the phase-outs work:
  • Personal and Dependent Exemptions - 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 $422,400 for 2015 and two children, for a total of four exemptions worth $16,000 (4 × $4,000). The threshold for a married couple is $309,900; thus, their income exceeds the threshold by $112,500. Each $2,500 part of this amount reduces the exemption by 2%; there are 45 parts of this amount ($112,500 ÷ $2,500 = 45). Thus, 90% (45 × 2%) of their $16,000 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,600 ([100%–90%] × $16,000). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $5,643 ($16,000 × 90% × 33%).

    Divorced or separated parents subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent. When 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 affected 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. The reduction is not to exceed 80% of the otherwise allowable itemized deductions.

    Not all itemized deductions are subject to the phase-out. The following deductions escape the phase-out:

    o Medical and dental expenses
    o Investment interest expenses
    o Casualty and theft losses from personal-use property
    o Casualty and theft losses from income-producing property
    o 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 $422,400 for 2015, 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 2015, Ralph and Louise had the following itemized deductions:

    Subject to Phase-out    Not Subject to Phase-out
    Home mortgage interest:
    $10,000
    Taxes:
    $8,000 
    Charitable contributions:
    $6,000
    Casualty loss:
    $12,000 
    Total: 
    $24,000
    $12,000 

    The phase-out is the lesser of $3,375 or $19,200 (80% of $24,000) which is $19,200. Thus, Ralph and Louise's itemized deductions for 2015 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, taxpayers who normally are not subject to a phase-out may have a high-income year because of unusual income. In these cases, it may be appropriate, if possible, to defer paying deductible expenses to the year following the high-income year or perhaps to deduct the expenses in the preceding year. The standard deduction is not subject to the phase-out. 

If you have questions about how these phase-outs will impact your specific situation, if you want to adjust your withholding or estimated taxes, or if you want to make a tax planning appointment, please give this office a call.

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