You have by now heard about the new tax increases, and a multitude of changes taxpayers will face going forward. While there are numerous changes, the two specific changes gathering the most press are 1) the increase in the top income tax rate (from 35% to 39.6%) and 2) the new, onerous Net Investment Income tax (NII). Both of these changes have serious impact, but there are a couple of other tax demons that have a much greater reach than increasing tax rates and the NII. Have you ever heard of PEP and Pease? PEP stands for Personal Exemption Phaseout and Pease (named for former congressman Donald Pease) is the acronym used for “We’re taking your Itemized Deductions away.”
A Brief, but Painful History
During former President Bill Clinton’s administration, we experienced a couple of seemingly simple yet powerful tax increases. These increases were referred to as PEP and Pease, and both created a relatively invisible yet deleterious effect on certain taxpayers’ personal exemptions and itemized deductions (thus, my rudimentary definition of ‘Shadow Taxes’). The purpose behind both was to reduce the income tax deductions of certain taxpayers as their income increased.
PEP (Personal Exemption Phaseout)
First we must define ‘personal exemption.’ Tax law entitles everybody a fixed personal tax deduction, basically for simply existing. So, you, your spouse, and your 2 children equal 4 total personal exemptions. Each personal exemption reduces your income by $x each year, with $x equaling a fixed amount adjusted for inflation. In 2013, $x is valued at $3,900. Then, to complete the example, if you have 4 personal exemptions, you have an immediate reduction in your income of $15,600, or $3,900 x 4 dependents. It’s the ‘gift’ Congress gives us.
In an effort to increase taxes, the Clinton administration said, if you make over a certain level of income, we’re going to renege on this gift. So, once taxpayers reached a certain level of adjusted gross income, their personal exemptions began disappearing. Bottom line, if you make a certain amount of money, the government thinks you don’t need this gift.
The Pease limitation is very similar to PEP in that it is a shadow tax (i.e. you think you’re receiving all your tax deductions, but strangely, you owe more tax). Like PEP, the Pease limitation begins reducing the value of your itemized deductions as your adjusted gross income reaches certain levels. So, as you get those raises and begin making more money, watch out! The deductible value of the mortgage interest you’re paying for that new home you bought has suddenly become less valuable. As a reminder, the three most common itemized deductions seen on tax returns are mortgage interest, real estate taxes, and charitable contributions.
Then, to complete the history portion of this article, during the George W. Bush presidency, PEP and Pease were eliminated, and this remained the law through Barack Obama’s first term. However, the “Fiscal Cliff” tax negotiations of late 2012 brought these limitations back in our lives.
Before I explain how PEP and Pease might affect you when you file your 2013 tax return and beyond, let’s look at two more quick definitions. You’ll notice I’ve used the term adjusted gross income several times so far; let’s make sure we all understand the difference between adjusted gross income and taxable income, as the difference is significant.
Adjusted gross income is your income from all sources less a few relatively obscure deductions (IRA contributions, student loan interest, moving expenses, and a few others). So, basically, adjusted gross income is your total income for the year unless you can reduce this income by any of the noted items.
Taxable income, on the other hand, is your adjusted gross income reduced by your itemized deductions and personal exemptions. Taxable income is the base amount on which your income tax is actually calculated.
PEP and Pease for 2013
So, let’s cut to the chase; here is how PEP and Pease may affect you and your 2013 income taxes:
PEP reduces the deductibility of your total personal exemptions by 2 percent for every $2,500 of income for married taxpayers with adjusted gross incomes over $300,000 and for single filers with adjusted gross incomes over $250,000. This entirely eliminates personal exemptions at $422,500 for married filers and $372,500 for single filers. You’re thinking that this is a huge amount, but remember our definitions from above. The thresholds are based, in effect, on your total income, not your income reduced by all your normal tax deductions!
The Pease limitation reduces your otherwise deductible itemized deductions by 3% for every dollar your adjusted gross income exceeds $300,000 for married taxpayers or $250,000 for single filers (note that items like casualty losses and gambling losses are excluded).
Again, remember the definition of adjusted gross income; in effect, the cumulative total of all your income less certain reductions if you have them. So, add up all your wages, interest, dividends, business income, retirement income, etc., and if you meet the magic income thresholds above, these two shadow taxes will cost you more income tax in 2013. The effect is tangible because as your income increases, your deductions decrease. A true double whammy.
The bottom line is that PEP and Pease will affect many more taxpayers than some of the other tax increases, because PEP and Pease begin costing you tax dollars based on your adjusted gross income (total income) as opposed to the new, widely-reported top tax rate of 39.6%, which is based on taxable income.
While our firm was preparing 2013 tax projections this past month, many of our clients were beyond being mad, they were mystified by these two tax provisions. PEP and Pease are a reality; we must all get ready for them. Short of any tax reform repealing these two ghosts, they are here to stay.