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Bryan Strike, MS, MTx, CFA, CFP®, CPA, PFS
March 31, 2015
The Pease limitation is named after Congressman Donald Pease who originally introduced the legislation in 1991, and it was added to the Internal Revenue Code under section 68. This provision limits the amount of itemized deductions allowed by reducing certain itemized deductions by the lesser of 3% of income over a threshold or by 80% of total deductions. The way the actual calculation works, however, is based on the adjusted gross income (AGI) of the taxpayer so this does NOT impact most taxpayer's incentive to donate to charity!
Reduction in Your Deduction
The idea behind the Pease limitation is to increase taxation on the higher income taxpayers without increasing their marginal table rate. As discussed in Collecting Social Security Benefits and Performing Roth Conversions, taxpayers can have a difference in their marginal table rate and their actual marginal rate. Since increasing the marginal table rates is more politically divisive, politicians achieved their objective of higher actual marginal rates of roughly 1% by hiding it in reduced deductions.
The calculation is pretty straightforward.
Reduce the itemized deductions allowed by the lesser of:
(AGI - threshold) * 3% or
Nonexempt Itemized Deductions * 80%
The threshold amount is indexed for inflation, but the 2015 amounts are listed below based on the taxpayer’s filing status:
Head of Household: $284,050
Married Filing Jointly: $309,900
Married Filing Separately: $156,000
Nonexempt Itemized Deductions are all itemized deductions except medical expenses, investment interest expense, casualty and theft losses, and gambling losses.
Income Based Reduction
Since the calculation for the reduction is based on a taxpayer's income you can honestly look at this provision as an increase in actual marginal rates. The Pease limitation applies to those taxpayers in the 33% marginal table rates and above. For most taxpayers in these brackets, the affect will simply be a surtax of their marginal table rate multiplied by 3%:
33% * 3% = 0.99%;
35% * 3% = 1.05%; and
39.6% * 3% = 1.188%.
Said differently, the actual marginal tax rate is the marginal table rate + marginal table rate on 3% of income over the threshold. This calculation can be extrapolated for the three tax brackets in a similar manner:
33% becomes 33.99%;
35% becomes 36.05%; and
39.6% becomes 40.788%.
Example 1: A single taxpayer has an AGI of $300,000 and nonexempt itemized deductions of $50,000. Assuming the Pease limitation does not apply, no personal exemption, and no other tax factors, she has a taxable income of $250,000, which equates to a tax liability of $66,106.
Since her AGI is $41,750 in excess of the applicable threshold, the Pease limitation will apply causing a "reduction in itemized deductions" of $1,252.50. Therefore, her taxable income is really $251,252 making her tax liability $66,519--$413 higher than without the Pease limitation.
Example 2: To illustrate the actual marginal tax rate, assume the same facts as in Example 1. If the taxpayer has an extra $1,000 of income she will owe $339.90 in tax. This is calculated as 33% on the $1,000 plus 33% on the $300 in lost itemized deductions. Alternatively, it is simply $1,000 * 0.3399.
Because this is an income related calculation, giving more to charity--or otherwise recognizing additional itemized deductions--will typically not be affected by the Pease limitation.
Example 3: Continuing from Example 1, if our single taxpayer decided to donate an additional $25,000 to charity, she would receive a full deduction for the contribution. Her AGI was $300,000, reduced by $75,000 in nonexempt itemized deductions, and increased by the Pease limitation of $1,252.50 for a taxable income of $226,252. That is $25,000 less in taxable income than the previous example, i.e. the amount of her charitable contribution.
80% Reduction Problems
While it is not a common issue, some taxpayers may have the 80% reduction rule apply, which makes additional itemized deductions, such as charitable contributions, less advantageous. In other words, there are situations where the reduction does apply to additional itemized deductions.
Example 4: A single taxpayer who has an AGI of $500,000 and nonexempt itemized deductions of $5,000. The taxpayer's AGI is over the threshold by $241,750 so 3% is $7,252.50. Since the taxpayer only has itemized deductions of $5,000 she will only have to reduce her itemized deductions by $4,000.
If she decided to donate $10,000 to charity her nonexempt itemized deductions increase to $15,000. Because 80% of her itemized deductions is now $12,000, she will reduce her itemized deductions by $7,252.50 instead of the $4,000 amount above. In other words, she contributed an additional $10,000 to charity but only got an additional deduction of $6,747. At a marginal table rate of 33% she only saves $2,227 in tax; a far cry from the $3,300 expected!
As shown in the example, the 80% limitation problem occurs when a taxpayer's income is very high and their itemized deductions are very low.[i] This mostly impacts those that have high income and live in low or no income tax states, rent rather than owning a home, or have paid off their mortgage. As long as the 80% limitation problem applies, only 20% of any additional itemized deductions actually provide a tax benefit for the taxpayer.
While the Pease limitation only applies to those with high income, it is important to consider the full impact of any tax laws on your actual marginal rate. Because the tax law is so complex, it is always important to consult with a professional prior to making financial decisions. As always, we are here to assist you in making these decisions so please reach out to your financial advisor for more information.
[i] In fact, the 80% limitation problem affects those whose itemized deductions are less than 3.75% of their excess AGI over the stated threshold. The 3.75% is equal to (3% / 80%) so the individual would run into this limitation if: Itemized Deductions < (AGI - Threshold) * 3.75%
This report and Mr. Strikes’ comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance.
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