"Itemized deductions." What a lovely pair of words! They can grant you a tax break for qualified medical, tax, interest, charitable, and other miscellaneous expenses.

Regardless of their income, many people think that itemized deductions will always help reduce their taxes. They cling to those deductions as tightly as Linus clung to his security blanket in Peanuts. But if your income exceeds certain levels, you might not get as much "bang for the buck" from those itemized deductions. It's just another way for Uncle Sam to generate more tax revenue without actually raising taxes.

The agony of AGI
A section in the tax code limits the amount of itemized deductions allowed to certain "high-income" taxpayers. The limit applies to any taxpayer whose adjusted gross income (AGI) exceeds $150,500 -- or $75,250 for a separate return filed by a married individual -- for tax year 2006. The good news is that this AGI limitation is "indexed" for inflation each year, so it'll be a bit higher for 2007. This $150,500 threshold, fairly or not, applies equally to both single and married or joint filers. You won't receive a higher threshold just because you're married and both you and your spouse work.

Anyway, if you're subject to this limitation, you're required to reduce the overall amount of your allowable itemized deductions by the lesser of:

  • 3% of the excess of adjusted gross income over the applicable amount, or
  • 80% of the amount of otherwise allowable itemized deductions.

Of course, to make things complicated, this limit doesn't apply to all deductions.

Deductions subject to the overall limit:

  • Taxes paid
  • Interest (except investment interest)
  • Charitable contributions
  • Job expenses
  • Most miscellaneous deductions

Deductions not subject to the overall limit:

  • Medical (and dental) expenses
  • Investment interest expense
  • Non-business casualty and theft loss
  • Gambling loss (to the extent of gambling winnings)

Please don't confuse the above limitations with the "normal" limitations with which you're likely familiar. For example, there's a 7.5% threshold for medical deductions, a 10% floor for casualty losses, and a 2% floor for miscellaneous deductions. The floors are based on the specific percentage of AGI.

For example...
Suppose that Carole, swami to the stars, has an AGI of $40,000. Her floor for miscellaneous deductions is 2%. This means she can only deduct qualifying items that exceed 2% of $40,000, or $800. If she has $700 in miscellaneous deductions, she's out of luck. If she has $900 in miscellaneous deductions, she can deduct $100 -- the amount by which the deductions exceed the floor.

As you can see, the hurdle is higher for medical deductions. Carole will only be able to deduct medical expenses that exceed 7.5% of her AGI -- in her case, $3,000.

But the "overall" limits for high-income taxpayers discussed above are in addition to any specific floors for medical deductions or miscellaneous itemized deductions.

Now let's assume Carole is still single, but that her AGI is much higher -- $195,000 for 2006. Carole has $17,125 in total medical expenses, but can only deduct expenses exceeding $14,625, or 7.5% of her AGI. In addition, Carole has $4,400 in miscellaneous deductions, but can only deduct the portion that exceeds $3,900, or 2% of her AGI. Given those factors, Carole has the following itemized deductions:

  • Medical: $2,500
  • Taxes: $3,100
  • Home mortgage interest: $19,500
  • Investment interest: $1,200
  • Charity: $4,000
  • Miscellaneous itemized deductions: $500

You might think that Carole's total itemized deductions would amount to $30,800 -- the grand total of all of the itemized deductions noted above. Sadly, you'd be very wrong. Because Carole is deemed a "high-income" taxpayer, with AGI greater than $150,500 for 2006, her itemized deductions will be limited. Her actual allowable itemized deductions amount to $29,910. In effect, Carole lost $890 in itemized deductions. Since Carole is in the 33% bracket, the reduction in her itemized deductions cost her an additional $294 in federal taxes. Ouch!

How can Carole determine how many of her itemized deductions will be snatched from her? She'll have to complete the worksheet for itemized deductions when she prepares her 2006 tax return. If you're curious, you can see use the 2005 worksheet as a guide for this exercise. Just remember to use the updated threshold amounts.

More deduction doom and gloom
The bad news just keeps on coming. Since many states also similarly limit itemized deductions for "high-income" taxpayers, Carole could be slapped around by her state tax agency as well. Furthermore, those "lost" itemized deductions are gone for good, with no provisions to carry them over to any future or previous tax years. Individuals with the highest incomes could see their itemized deductions slashed by as much as 80%. Others, such as Carole, will just get a punch to the kidney.

What could Carole have done to avoid this? Not much, with the possible exception of keeping her income below the $150,500 limitation. This might be possible for many of you, but for other folks who realize a large portion of their AGI in wages or other "fixed" income, it may simply be impossible. Those unfortunate taxpayers can only search for a large bullet to bite.

If your AGI is above the limit, you'll lose your grip on some of your itemized deductions. Don't be caught by surprise.

When he's not dealing with tax issues, Fool contributor Roy Lewis is a motivational speaker who lives in a trailer down by the river. He understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns, as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.