Stealth Tax Increases End Eventually
They are derisively characterized as stealth, or backdoor, increases because their effect is to increase taxes without increasing rates. They work their mischief with a double whammy on affluent individuals who’re deemed to be undeserving because their AGIs, short for adjusted gross income, are above specified amounts. (AGI is the amount on the last line of page one of Form 1040.)
For starters, their dependency exemptions are phased out, that is, gradually reduced. Next is a limitation on most of their itemized deductions. Both curtailments are indexed, meaning, they’re automatically adjusted each year to reflect inflation.
For 2001, exemptions begin their phase out when AGI surpasses $132,950 for singles, $199,450 for joint filers, $166,200 for heads of household and $99,725 for marrieds filing separately.
The disallowance of most itemized deductions is 3 percent of the amount by which 2001’s AGI exceeds $132,950 ($66,475 for marrieds filing separately; going that route does not increase a couple’s threshold to a combined $265,900). Put another way, every $1,000 of AGI above $132,950 results in the loss of $30 of itemized deductions.
The 3 percent restriction applies to deductions for interest on home mortgages, real estate taxes, state and local taxes, charitable contributions, and miscellaneous expenses (already allowable, in most cases, just for the amount above two percent of AGI).
Four kinds of write-offs merit reprieves. But the exceptions are for deductions already subject to limitations. The 3 percent rule doesn’t apply to: (1) medical expenses (deductible only for the amount above 7.5 percent of AGI; (2) casualty and theft losses (allowable only to the extent such uninsured losses exceed $100 (for each casualty or theft), plus 10 percent of your AGI); (3) gambling losses (allowable just to the extent of gambling winnings); and (4) interest on funds borrowed to finance investments, such as margin accounts used to buy stocks (allowable just to the extent of investment income, a category that includes dividends, interest and, subject to restrictions, capital gains).
EXAMPLE. Abigail and Arthur Adams anticipate an AGI for 2001 of $192,950, and their otherwise allowable itemized deductions for charitable donations, home-mortgage interest, real estate taxes and the like aggregate $20,000. So the couple’s income tops the $132,950 threshold by $60,000. Three percent of $60,000 equals $1,800, so their deductions are capped at $18,200 and their forfeiture is $1,800.
The law subjects them to the same $1,800 disallowance, whether they have deductions of $20,000 or $100,000; the disallowance is based on the amount by which AGI exceeds $132,950, not total deductions. But this curtailment can’t cause them to sacrifice more than 80 percent of total deductions. Abigail and Arthur always are allowed to deduct 20 percent of them.
The new law authorizes relief for people like the Adamses, but not right away. It begins a gradual elimination of the automatic cutbacks in 2006 and wraps things up in 2009. After that, they’ll be able to deduct all of their exemptions and itemized deductions, no matter how high their AGIs. This is equivalent to further reducing the top rates by about one percentage point, and, as a sort of congressional afterthought, actually simplifies the tax code.
Julian Block is an attorney and former IRS investigator who has been cited by the New York Times as "a leading tax professional" and by the Wall Street Journal as an "accomplished writer on taxes." His "Year-Round Tax Savings" shows how to save truly big money on taxes – legally – and explains the steps you should take to reduce taxes for this year and even gain a head start for future years. To order the publication, send $9.95 for a printed copy or $8.95 for an e-mail version to
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