Itemized deductions seem to be a simple enough concept. The government decides which personal expenditures of taxpayers deserve a tax break, with the taxpayers' benefit, in theory, based on their tax rate. Unfortunately, as with most rules in our tax code, it is a bit more convoluted. Two reasons it is not so simple are the Alternative Minimum Tax and the itemized deduction phase-out.
Alternative Minimum Tax
affects more people every year, because it was never indexed for inflation. High-income people living in states with high property and state income taxes bear the brunt. Effectively, a portion of their itemized deduction is eliminated because state income taxes and property taxes are AMT-preference items.
Imagine a married couple with two kids living in New Jersey making $750,000 a year. They have gross itemized deductions of $101,984, including their state income tax liability of $49,784 and $20,000 of residential property taxes. The couple would have an AMT tax liability of $7,496 solely because of these two preference items. Since the couple is in the 28% marginal bracket, the AMT has effectively wiped out 38% of their state income and property tax benefit. The math works as follows:
A tax benefit of $69,784 times 28% equals $19,539. That AMT tax liability of $7,496 accounts for 38% of it, leaving a net benefit of $12,043, or 62%.
The itemized deduction phase-out
for high-income earners is eliminated for this year but set to return in 2011. The phase-out amount is 3% of AGI above a threshold amount of $166,800 (for married couples filing separately, $83,400). The phase-out is capped at 80% of the itemized deduction amount. For this year the hypothetical couple above would have no phase-out of their itemized deductions. But flash forward to next year and the couple, assuming the exact same itemized deductions, would have $17,400 of their itemized deductions phased out.
Current thinking is that high-income earners should push their itemized deductions when possible into next year because higher tax rates will make them more valuable. On the surface, it would appear someone in the 35% bracket headed into the 39.6% bracket would automatically be better off pushing itemized deductions to next year. But it's not necessarily better if you get a higher percentage of a smaller base!
When tax planning for itemized deductions, you really need to run the numbers to account for AMT and the phase-outs. Doing it on the back of an envelope just doesn't cut it.
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Michael Maye is the founder and president of MJM Financial Advisors, a registered investment advisory firm in Berkeley Heights, N.J. He is a member of the National Association of Personal Financial Advisors (NAPFA) and has been a speaker covering tax topics at NAPFA's national and regional conferences. Maye has also been a frequent contributor to the Star Ledger of New Jersey's 'Biz Brain' and 'Get With the Plan' articles. In addition to NAPFA, he is a member of Financial Planning Association, American Institute of Certified Public Accountants, New Jersey State Society of CPAs and the Estate Planning Council of Northern New Jersey.