Limbo Your Way to Lower Taxes

Last Updated May 13, 2010 2:47 PM EDT

Most days, being well-off is preferable to not being well-off.
Not on April 15. That's the day that anyone with what's
deemed a high income is left out in the cold while everyone else has a
tax-deduction party. The usual mechanisms for this exclusion are
what's known as "phase-outs." Once your adjusted
gross income (AGI) exceeds certain thresholds, you start losing some deductions
and credits; at some level of income, the write-offs evaporate entirely.
It's too late to beat the phase-outs for your 2008 taxes. But you may
be able to skirt them for your '09 taxes and beyond by taking
advantage of "above-the-line" deductions that can let you
limbo under the income thresholds. If you're in the sweet spot
— singles earning $75,000 to $100,000 and couples earning as much as
$200,000 — learning to stay under the thresholds can save you a small
fortune in taxes.

The Major Phase-Outs

The list of tax breaks that phase out at certain levels of
adjusted gross income is long and growing — 25 at last count, says Mark
Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based
publisher of tax information.

Some of the most significant on 2008 returns and beyond:

  • Child
    tax credit
    of $1,000 per dependent under age 17 starts
    to phase out at $75,000 for singles, $150,000 for married

  • Hope
    tax credit
    to finance college bills of a freshman or sophomore starts to
    phase out at $48,000 for singles, $96,000 for couples

  • Lifetime
    learning credit
    for education expenses starts to phase out at $48,000 for
    singles, $96,000 for couples

  • Tuition
    and fees deduction
    , which can reduce taxable income by up to $4,000, begins
    to phase out at $65,000 for singles, $130,000 for couples

New phase-outs for 2009 returns:

  • First-time
    homebuyer tax credit
    of $8,000 begins to
    phase out at $75,000 for singles, $150,000 for couples

  • Adoption
    tax credit
    starts to phase out for both singles and married couples at
    $174,730 in income

  • American
    Opportunity tax credit
    of up to $2,500 per college student starts to phase
    out at $80,000 for singles, $160,000 for couples

  • Making
    Work Pay
    tax credit starts to phase out at $75,000 for singles,
    $150,000 for couples

  • Vehicle
    purchase deduction
    , to offset sales taxes on new cars bought in 2009,
    starts to phase out at $125,000 for singles and couples

Avoid the Phase-Outs

There’s really only one way around the
phase-outs: to reduce your adjusted gross income enough that you dive under the
phase-out thresholds. Other than earning less money — not recommended
— the only strategy is to claim the most you can in above-the-line
deductions. They range from self-employment retirement plan savings to
rental-income expenses, and they work because, unlike most deductions, they’re
subtracted before adjusted gross income is calculated. The more you can
hack away at your income above the line the more you can drive your AGI below
the phase-out thresholds and increase your write-offs.

Here’s how to do it:

  • Save
    for retirement in a tax-favored plan
    . You can set aside up to $16,500 a
    year (more if you are 50 or older) in an employer-sponsored retirement plan,
    such as a 401(k) or 403(b). We know, we know. You never want to put another
    penny in a plan that can lose 50 percent in a year. Well, you don’t
    have to put the money in stock funds, and you can still get the above-the-line
    write-off. The self-employed can save up to 25 percent of their self-employment
    income each year, or $46,000.

  • Use
    your employer’s pretax plan for child care or health care expenses
    A dependent care account might let you set aside up to $5,000 annually to pay
    for a nanny, preschool, or summer day care. A health savings account allows you
    to save for medical bills that aren’t covered by insurance, such as
    orthodontia and elective surgery. Let’s say you and your working
    spouse earn $140,000 in joint income and have $8,500 in day-care bills plus
    unreimbursed medical expenses such as deductibles and orthodontia. Pay the
    $8,500 through pretax savings accounts and you cut your adjusted gross income
    from $140,000 to $131,500.

Assuming a 30 percent marginal tax bracket, a couple who
paid for day care and health expenses through tax-advantaged accounts
(qualifying them, too, for $5,000 in income-tested child tax credits) and saved
$11,000 apiece in employer-sponsored savings plans could save $10,650 in taxes
by bringing their AGI below the thresholds for key tax breaks.

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    Kathy Kristof is an award-winning financial journalist and the author of Investing 101.