Income Tax Traps: Don't Let Them Trip You Up

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Money TrapWhatever happened to tax reform? National news has been focusing on different issues recently but the effort to reform the tax code is far from finished. Unfortunately our two political parties have very different ideas on how income taxes should be restructured. A tax reform plan was proposed earlier this year from Republicans Marco Rubio (FL) and Mike Lee (UT) which would flatten tax rates and replace some popular deductions with tax credits. All investment income (interest, dividends and capital gains) would be tax free and the alternative minimum tax and estate tax would be eliminated. Democrats prefer reform based on expanding the earned income and child credits. They would like to increase the education credit and expand the expenses eligible for the dependent care credit. A new credit for working couples with children under age 12 has also been proposed. The two sides are not even close.

Regardless of what happens with tax reform, you could trigger a tax increase or decrease depending on your income and deductions. The tax code is filled with tax traps that can be tripped when your income, or sometimes your deductions, reach certain thresholds. Knowing where the trigger points are and how to avoid them can make a big difference at tax time.

Alternative Minimum Tax (AMT) – AMT was reformed in the American Taxpayer Relief Act of 2012 but continues to affect millions of taxpayers. AMT is 26% of the first $185,400 of income (AMT taxable income) and then increases to 28%. AMT taxable income is calculated by removing certain deductions when a taxpayer itemizes. Some tax credits are allowed (child credit, adoption credit, American Opportunity, and dependent care) while others are not. Joint filers get an $83,400 exemption and singles get $53,600 but the exemptions are phased out at $158,900 and $119,200 respectively. Taxpayers affected by the AMT need to carefully plan income and deductions to avoid the tax because it is based on the ratio. There would be no point in accelerating deductions in a year when they would be disallowed.

Social Security Taxation – Retirees with income below the base amounts of $25,000 (single filer) and $32,000 (joint filer) are not subject to federal personal income tax on their Social Security benefits. When income exceeds these thresholds, tax applies to some percentage of benefits. For joint filers with incomes above an “adjusted base amount” of $44,000, up to 85% of benefits can be taxed. Itemized deductions do not affect the taxation formula. Income will need to be restructured to minimize the tax on Social Security benefits.

Medicare Surtax – The surtax is an additional 3.8% tax on the lesser of net investment income or modified adjusted gross income (MAGI) over $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers. The tricky part of this tax is defining what is “net investment income” (NII). NII subject to surtax generally includes interest and dividend income as well as capital gains from investments. Distributions from nonqualified annuities are included but distributions from IRAs and qualified retirement plans are not. Tax-exempt municipal bonds and distributions from qualified annuities are also excluded. See my three part series “9 Ways to Beat the Medicare Surtax” for strategies to minimize this tax.

PEP and Pease limitations – The personal exemptions phase-out (PEP) and the phase-out for itemized deductions (Pease limitation) were both restored in American Taxpayer Relief Act of 2012. The Pease limitation reduces all itemized deductions by 3% of excess income over an adjusted gross income (AGI) threshold. The AGI thresholds for 2015 are listed below. These amounts are indexed annually for inflation.

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Source: US Tax and Financial Services (

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.

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 $4,000 in 2015.

Means Tested Medicare Premiums Parts B & D – Medicare premiums were the same for everyone until 2007. Higher premiums applied only for Medicare Part B until health care reform froze the income thresholds and extended the higher premiums to Medicare Part D covering prescription drugs. Medicare looks at your most recent federal tax return and bases the higher premiums on your modified adjusted gross income (MAGI) plus your tax-exempt interest.

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Reducing your Medicare premiums requires careful planning before the end of the year. Several strategies for managing your MAGI to stay under the income thresholds can be found in “It Takes Planning to Reduce Your Medicare Premiums.”

Don’t wait until next March to look for ways to minimize taxes in 2015. Keep an eye on these tax traps and take steps to avoid them before the end of the year.

Rick’s Tips:

  • The tax code is riddled with triggers that can cause your effective tax bracket to jump considerably.
  • Minimizing taxes is not only about controlling income. Some tax traps are triggered by deductions and their ratio to total income.
  • Upper income taxpayers are not the only ones affected by tax traps. Retirees with income above $25,000 can trigger the taxation of their Social Security benefits.

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