New Rules for Itemized and Personal Exemptions

Rick Rodgers
Planner-Adviser

The phase-out of itemized deductions and personal exemptions is back. Taxpayers with income between $200,000 and $400,000 ($250,000 and $450,000 for couples) did not escape higher taxes in the American Taxpayer Relief Act of 2012 (ATRA12). These taxpayers will be paying the old Bush tax cuts rates, but on a larger piece of their income, in addition to the new Obamacare taxes taking effect in 2013.

The phase-out for itemized deductions (Pease limitation) reduces all itemized deductions by 3% of excess income over an adjusted gross income (AGI) threshold. The AGI threshold in ATRA12 is $250,000 for single taxpayers ($300,000 for married couples). These amounts will be indexed for inflation in future years. However, deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses are not subject to Pease limitations. The maximum amount that can be lost is no more than 80% of the affected itemized deductions. Unfortunately, the most popular itemized deductions – charitable contributions, state & local income taxes, and mortgage interest – will all be reduced for affected taxpayers.

ATRA12 also restores the personal exemptions phase-out (PEP). PEP reduces personal exemptions by 2% of the total exemptions for each $2,500 of excess income over the AGI threshold using the Pease limitation. Each personal exemption you’re entitled to fully deduct (for yourself, your spouse, and your dependents) will reduce your taxable income by as much as $3,900 (estimated inflation-adjusted exemption for 2013).

The net impact of the PEP and Pease limitations is that each rule increases an individual’s marginal tax rate by about 1% (with a greater impact on larger families that phase-out more exemptions at once). Careful planning is needed for affected taxpayers, especially those with a child earning income. Those taxpayers may want to pass up the exemption for their child, allowing the child to take their own personal exemption.