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Disappearing deductions cost taxpayers

Changes to tax laws last year reinstated some income-based phase outs of some widely used personal exemptions and itemized deductions, leaving many taxpayers with higher tax bills.

Hardest hit will be those with higher incomes, who will be disappointed to see that deductions they previously claimed on their 2012 tax returns have been reduced or eliminated.

The Personal Exemption Phase Out

Typically tax payers are allowed to claim an exemption for themselves and any other joint filer and dependent on their tax return. The personal exemption is a defined amount - $3,900 for 2013 - which is used to reduce their income before figuring the amount of tax they owe. But starting with 2013 tax returns, single filers with adjusted gross income (AGI) in excess of $250,000 or those who are married filing jointly and have AGI in excess of $300,000 will be subject to a phase out of their personal exemptions.

Talking taxes: What you need to know for tax season 2014 02:43
The phase out of the personal exemption works like this. For every $2,500 of AGI (or portion) above $250,000 ($300,000 for married filing jointly), the $3,900 per-person personal exemption amount is reduced by 2%. For married couples, personal exemptions are fully phased out once their AGI exceeds about $422,000, and for single filers their personal exemptions are phased out when their AGI exceeds about $372,000.

Here is an example of how this might affect a taxpayer:

If you are in the 35 percent federal tax bracket, the loss of each $3,900 personal exemption increases your taxes by $1,365. If you want to know how your tax return is impacted, look at line 42 of Form 1040, to see the amount of the personal exemptions you are allowed to claim on your tax return and compare that to the amount that results by multiplying $3,900 by line six (which is the number of personal exemptions you are allowed to claim.)

The Itemized Deduction Phase Out

The tax changes also brought back the phase out of itemized deductions in 2013. Like the phase out of personal exemptions, this also affects taxpayers whose incomes exceed certain amounts. For these taxpayers, their deductions for things like mortgage interest, state income and sales tax, and certain other itemized deductions are reduced, but not fully eliminated. This reduces the amount of itemized deductions claimed on Schedule A by three percent of the AGI above $300,000 for couples, and over $250,000 for single filers. The maximum reduction of itemized deductions is set at 80 percent. Itemized deductions for medical expenses, investment interest, and for casualty, theft, or gambling losses are not subject to this phase out.

Here is an example of how this might affect a taxpayer:

Assuming a married couple has an AGI of $500,000 and the total of their mortgage interest, state and real property taxes and charitable contributions paid in 2013 was $70,000. Since their AGI is $200,000 over the $300,000 limit for purposes of the itemized deduction phase out, then this amount is multiplied by 3 percent, resulting a reduction amount of $6,000. Their itemized deductions allowed to be claimed on line 40 of their Form 1040 are reduced from $70,000 to $64,000. If they are in the 35 percent tax bracket, this loss of $6,000 of their itemized deductions results in additional tax of approximately $2,100.

While these reductions of exemptions and phase outs are an unwelcome addition to the 2013 tax season, there are some things taxpayers can do to reduce the impact on their personal situation in 2014. Check back in a few days when I'll write about some tax planning strategies to consider in 2014 to reduce the tax impact of these phase outs.

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