Generally, in 2016 and 2017 taxpayers are allowed to deduct personal exemptions of $4,050 for themselves, their spouses and their dependents. In addition, taxpayers are allowed a standard deduction or, if their deductions are large, they can itemize their deductions. .

However, the personal exemptions and itemized deductions for higher income taxpayers are phased out beginning when a taxpayer’s adjusted gross income (AGI) reaches a phase-out threshold amount.

The threshold amounts are based on the taxpayers’ filing statuses and for 2017 are: $261,500 (up from $259,400 for 2016) for single filers, $287,650 (up from $285,350 for 2016) for individuals filing as heads of households, $313,800 (up from $311,300 for 2016) for married couples filing jointly and $156,900 (up from $155,650 for 2016) for married individuals filing separately. Here is how the phase-out works:

  • Personal Exemption – 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 $426,300 for 2017 and two children for a total of four exemptions totaling $16,200 (4 × $4,050). The threshold for a married couple is $313,800; thus, their income exceeds the threshold by $112,500. Dividing $112,500 by $2,500 equals 45. So 90% (45 × 2%) of their $16,200 exemption allowance is phased out, leaving them with a reduced exemption deduction of $1,620 ((100%–90%) × $16,200). Assuming Ralph and Louise are in the 33% federal tax bracket, the phase-out costs them an additional $4,811 ($16,200 × 90% × 33%) of tax. 

    A divorced or separated parent subject to the phase-out should consider relinquishing the exemption of a dependent child to the other parent. Where 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 hit 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, with the reduction not to exceed 80% of the otherwise allowable itemized deductions.

    Not all itemized deductions are subject to phase-out. The following deductions are not subject to 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 $426,300 for 2017, 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 2017, Ralph and Louise had the following itemized deductions: 
        Subject to Phase-out Not Subject to Phase-out
    Home mortgage interest
    Charitable contributions
    Casualty Loss   
    The phase-out is the lesser of $3,375 or $19,200 (80% of $24,000). Thus Ralph and Louise’s itemized deductions for 2017 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%) of tax. 

    Conventional thinking is to maximize deductions. However, where taxpayers normally are not subject to a phase-out and have a high-income year because of unusual income, it may be appropriate, where possible, to defer paying deductible expenses to the year following the high-income year or perhaps pay and deduct the expenses in the preceding year if the out-of-the-ordinary additional income is planned for in advance.

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

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