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Taxes will rise for more than just the ultra-wealthy

Taxes will rise for more than just the ultra-wealthy

The big numbers under discussion following the American Taxpayer Relief Act of 2012 have been $400,000, the income level where new marginal rates kick in for singles, and $450,000, for married couples filing jointly.

But two limitations on tax breaks for high-income earners are returning at much lower income thresholds, amounting to something of a stealth increase. And there are few ways to get around them.

Even if you think you are not rich enough to worry about higher taxes under the new agreement, these two haircuts may affect you because PEP and Pease, as they are called, come into play at $250,000 for singles and $300,000 for married couples.

Combined, the two rules effectively raise taxes on the affluent without increasing marginal tax rates. Both had been temporarily eliminated by the Bush tax cuts and do not apply to your 2012 taxes. They are back for 2013, though, as part of the tax agreement reached in the fiscal cliff negotiations at year-end.

You may tear your hair out trying to sort through the details, but there is one reason to count your blessings: If not for the fiscal-cliff deal, the income thresholds would have been far lower (Pease at $89,075 for singles and $178,150 for married couples, and PEP at $178,150 for singles and $267,200 for marrieds).

And that means millions of taxpayers do not need to worry about them.


PEP, the personal exemption phase-out, lowers each personal exemption that taxpayers are allowed to take for themselves and their dependents by 2 percent for each $2,500 of household income above the threshold.

For the 2013 tax year, the personal exemption will be $3,900. So for each $2,500 step-up, you would lose $78 of each exemption.

For example, a couple making $350,000 would have two exemptions and would be $50,000 over the threshold. So they would lose $3,120 of their total $7,800 in exemptions. A family of four at the same income level would have four exemptions totaling $15,600 but would lose $6,140 of that due to PEP.

But some taxpayers at that level will end up owing the Alternative Minimum Tax where those exemptions are not valid.

"Planning around PEP is counterproductive because of the interaction with the Alternative Minimum Tax," says Bill Fleming, managing director at PwC's private company services practice. "It's all about Pease."

The Pease limitation on itemized deductions dates back to 1990 and is named for the late U.S. Representative Don Pease of Ohio. Along with PEP, it was phased out by the Bush tax cuts, disappearing completely in 2010.

Under the new Pease rules, many popular Schedule B deductions like mortgage interest, state and local taxes, and charitable contributions will get shaved down. The haircut is 3 percent of the amount your income is over the threshold of $250,000 for singles or $300,000 for married couples. (Pease does not apply to medical expenses or casualty and theft losses.)

To understand how these new rules will affect you, figure out how much you will exceed the income limit and then calculate 3 percent of that amount.

For the couple making $350,000 in adjusted gross income, 3 percent of the $50,000 that they are over the limit is $1,500. If the couple has $60,000 of itemized deductions, they would only be able to claim $58,500. The higher the overage, obviously, the greater the impact on the deductions allowed.

Remember: This will not actually cost you $1,500, in that example, but would increase your taxable income by $1,500. For many affluent taxpayers, "it's not a huge number," says PwC's Fleming. "If you make millions, it's a big number."


Can you plan around PEP and Pease? It is not so easy, since first you need to know your adjusted gross income – something very few people think about until they do their tax returns because there are so many moving pieces.

Kaye Thomas, author of the tax-planning site Fairmark, notes that adjusted gross income includes capital gains, so selling securities or other assets can trigger the restrictions. Pay careful attention this year if you plan to sell your business or your home.

If you suspect that you will be close to the threshold limitation, you could try to lower your income by deferring it or prepaying expenses at year-end. You could also put off taking individual retirement account distributions above the required minimum.

© Copyright 2013 Thomson Reuters. 

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