How "Stealth" Taxes Can Cost You

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Stealth taxes are not a line item you'll find on your income tax return. But millions of taxpayers end up paying them without even knowing they exist. Only by learning about stealth taxes can you take action to try to avoid them.

The basics of stealth taxes
Most people know that our tax rate on each additional dollar of income rises as we reach higher income levels. However, there's more to your total tax bill than higher tax brackets.

Say you're in the 25% tax bracket. You generally expect to pay 25% in federal income taxes on every additional dollar you make. If you could swear you're paying more than that, you may actually be right. There's a good chance you're paying higher taxes thanks to what I call "stealth taxes" -- the loss of tax benefits as your income rises past certain thresholds in the tax code. Rather than raising the tax rate -- a politically unpopular move -- the tax code phases out or eliminates your tax credits and other benefits when you make too much money.

High-income phase-outs: Not just for rich people
If you think you don't make enough money to lose out on tax breaks due to high income, think again. Many thresholds hit middle-income taxpayers right on the chin.

One example of how stealth taxes can hit ordinary Americans is education credits. If you have a kid in college, you may start to lose the benefits of certain tax credits at income levels as low as $52,000, depending on the credit and your filing status.

Education credits are fabulous -- if you can get them. The Lifetime Learning Credit pays back 20% of the first $10,000 you spend on tuition and other qualified expenses for yourself, your spouse, and qualifying dependents. That's a tax credit of up to $2,000.

But you start to lose that credit when your modified adjusted gross income (basically your total income before itemized deductions) is more than $52,000 (in 2014), if you are single. By the time your modified adjusted gross income, or MAGI, hits $62,000 -- hardly enough money to put you on Easy Street -- the credit is gone. If you're married filing jointly, the credit starts to phase out at an MAGI of $104,000 and disappears completely when your MAGI reaches $124,000.

Not all tax breaks phase out at the same income levels. The American Opportunity Credit is available to taxpayers in slightly higher income brackets. This education credit pays 100% of the first $2,000 you spend on you spend on tuition and other qualified expenses for yourself, your spouse, and qualifying dependents, plus 25% of the next $2,000, for a total credit of up to $2,500.

For the American Opportunity Credit, if you're single, your modified adjusted gross income can be up to $80,000 (in 2013) before it starts to be phased out. It's gone when your MAGI hits $90,000. If you're married filing jointly, the credit starts to phase out at an MAGI of $160,000 and disappears completely when your income reaches $180,000.

Common tax breaks and phase-out levels
For 2013, check out these income phase-out levels for common tax breaks:

Tax benefit Phase-Out Range (filing single) Phase-Out Range (filing jointly)
Child tax credit $75,000-plus $75,000-plus
American Opportunity Credit $80,000 to $90,000 $160,000 to $180,000
Lifetime Learning Credit $52,000 to $64,000 $108,000 to $128,000
Adoption credit $197,880 to $237,880 $197,880 to $237,880
Tuition deduction* (may not be renewed for 2014) $65,000 to $80,000 $130,000 to $160,000
Student loan interest deduction $60,000 to $75,000

$125,000 to $155,000

Retirement savings credit $17,750 to $29,500

$35,500 to $59,000

Your tax benefit begins to phase out when your adjusted gross income, with certain modifications, is more than the lower end of the phase-out range. You cannot take the tax benefit if your adjusted gross income is more than the higher end of the phase-out range.

If you file as head of household or as married filing separately, your phase-out levels may be different. Some phase-out levels for 2014 are adjusted for inflation.

Itemizing deductions doesn't help
You can't lower your modified adjusted gross income by taking itemized deductions. Mortgage interest expense, charitable contributions, and other itemized deductions reduce your taxable income after MAGI. The same goes for dependency exemptions. They have no effect on your modified adjusted gross income.

Because your MAGI is the amount the IRS uses to determine whether certain tax breaks are phased out, itemized deductions and dependency exemptions do not help you avoid phase-outs of tax breaks due to high income. 

Tax planning for stealth taxes
You wouldn't turn down a raise because it would put you in a higher bracket and make you lose tax breaks. So long as your tax rate on incremental income is less than 100%, you're always better off earning a dollar than passing it up.

What you can do is plan ahead to lower your adjusted gross income in years when you may qualify for certain breaks.

You may be able to time your income and other tax items. For example, you can put off selling an investment at a gain so you still get that education credit or other tax benefit.

One of the best ways to lower your adjusted gross income and thus qualify for more credits and other breaks is to contribute to a qualified retirement account. Deductions from your paycheck into a traditional 401(k) plan reduce the amount of income you report on your tax return, and thus your adjusted gross income. If you make contributions to a retirement plan yourself, such as a traditional IRA, these also reduce your adjusted gross income.

Contributions to Roth IRAs and Roth 401(k) plans do not reduce your adjusted gross income or taxable income.

You can't change the IRS rules, but you can plan for them. Understanding how tax breaks are phased out at certain levels income is a good first step for better tax planning in 2014.

Be smart about your taxes for 2014
Knowing about stealth taxes is just one way to get yourself smarter about your tax bill in 2014. In our brand-new special report "How You Can Fight Back Against Higher Taxes," The Motley Fool's tax experts run through what to watch out for in doing your tax planning this year. With its concrete advice on how to cut taxes for decades to come, you won't want to miss out. Click here to get your copy today -- it's absolutely free.

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Sally Herigstad

Sally is a new Fool contributor for 2014, but a long-time personal finance writer, columnist, and certified public accountant. Sally wrote "Help! I Can't Pay My Bills" for St. Martin's Griffin.

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