Higher-Income Benefits Fade
Sunday, February 26, 2006
Seeing one's income rise is generally a good thing, but in a country with a progressive income tax, it is not an unalloyed benefit.
Higher income generally means higher taxes -- and in some cases, higher than taxpayers might expect from looking at the broad outlines of the tax law.
This is because Congress, while cutting tax rates and adding various tax breaks, has also been quietly including or leaving in place all sorts of income ceilings and phase-outs that can undo a lot of the benefits. The impact of these "claw-backs" is found at virtually all income levels, but it is especially apparent for taxpayers at the top of the middle class and slightly beyond.
Thus it is that many such taxpayers go into the filing season with visions of deductions and credits dancing in their heads, only to find themselves phased out of benefits they could really use.
It's a theme Pamela F. Olson, former assistant Treasury secretary for tax policy, said she has seen since the big round of tax cuts in 1997.
"People thought they were going to get terrific benefits based on all the hype," only to discover otherwise when they did their returns, she said.
Two of the most insidious provisions are known in tax circles as PEP and Pease, which kick in at incomes slightly above $140,000 for some taxpayers.
Pease, so called after the late Ohio congressman Donald J. Pease (D), who thought it up in 1986, is a limitation of itemized deductions. PEP stands for personal exemption phase-out. It is a provision that starts reducing the value of personal exemptions -- otherwise worth $3,200 per taxpayer, spouse and dependent for 2005 -- for wealthier taxpayers.
Pease, which the Internal Revenue Service refers to as the limit on itemized deductions, applies to both married and single taxpayers with adjusted gross income of more than $145,950.
Pease doesn't wipe out all your deductions. Some -- such as medical expenses, investment interest, casualty and theft losses and gambling losses -- are not subject to the limit. And those that are limited -- which include state and local taxes, interest and gifts to charity (though there is an exception for certain donations made after last year's hurricanes) -- are reduced by 3 percent of the amount that your adjusted gross income exceeds $145,950, though it won't erase more than 80 percent of the value of the limited deductions.
PEP has its own complexities. Beginning at certain income levels -- $145,950 for singles, $218,950 for married filers -- taxpayers must begin reducing the value of their personal exemptions. The reduction is gradual. For each $2,500 (or part of $2,500) by which a taxpayer's adjusted gross income exceeds the threshold, he or she must reduce the value of personal exemptions by 2 percent. And you keep taking 2 percent away until you've either accounted for all of your income or the value of your personal exemptions has been reduced to zero.
The net effect of PEP and Pease is to make tax brackets that are nominally as low as 28 percent higher than they appear. This is because if you are subject to one or both and you add one dollar to your income, not only is that dollar taxed at the nominal rate but the exemption phase-out also makes taxable some portion of a previously untaxed dollar.