"Itemized deductions." What a lovely pair of words! They give you a tax break for qualified medical, tax, interest, charitable, and other 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. Uncle Sam, after all, finds ways 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 that certain high-income taxpayers can take. The limit applies to any taxpayer whose adjusted gross income (AGI) exceeds $156,400 -- or $78,200 for a separate return by a married individual -- for tax year 2007. The good news is that this AGI limitation is indexed for inflation every year, so it'll be a bit higher for 2008.
This $156,400 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 you and your spouse both work.
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 AGI over the applicable amount, or
- 80% of the amount of otherwise allowable itemized deductions,
multiplied by two-thirds.
Of course, to make things even more complicated, this limit doesn't apply to all deductions.
Deductions subject to the overall limit are:
- 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 losses, to the extent of gambling winnings.
Please don't confuse these limitations with the normal limitations with which you're probably 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 deduct only 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 can deduct only medical expenses that exceed 7.5% of her AGI -- in her case, $3,000.
But the overall limits for high-income taxpayers we 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 2007. Carole has $17,125 in medical expenses, but she can deduct expenses only exceeding $14,625, or 7.5% of her AGI. In addition, Carole has $4,400 in miscellaneous deductions, but she can deduct only 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 Carole's total itemized deductions would amount to $30,800 -- the grand total of all of the itemized deductions noted above. You'd be very wrong. Because Carole is deemed a high-income taxpayer, with an AGI greater than $156,400 for 2007, her itemized deductions will be limited. Her actual allowable itemized deductions amount to $30,028. In effect, Carole lost $772 in itemized deductions. Since Carole is in the 33% bracket, the reduction in her itemized deductions cost her an additional $255 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 2007 tax return. If you're curious, you can see the 2007 worksheet to use as a guide for this exercise.
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's state tax agency could slap her around 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 53.3%. Others, such as Carole, will just get a punch to the kidney.
What could Carole have done to avoid this? Not much, with the potential exception of keeping her income below the $156,400 limitation. That 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. The only thing these unfortunate taxpayers can do is 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.
This article was originally published on Sept. 15, 2006. It has been updated.
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.