The Tax Hit You May Not See

Phaseouts, Which Limit Tax Breaks Based on Income, Come Under Renewed Fire; What to Watch Out For

January 10, 2007; Page D1

Millions of people are paying taxes at higher rates than they probably realize because of tricky provisions that can reduce -- or even eliminate -- major tax breaks based on their income.

These so-called phaseouts (because some benefits begin to phase out when your income exceeds certain levels) and similar provisions should be repealed, or at least simplified, said Nina Olson, the Internal Revenue Service's National Taxpayer Advocate, in a report to Congress released yesterday. Ms. Olson, who isn't a political appointee, heads an IRS unit designed to help taxpayers cut through red tape and deal with problems that typically couldn't be resolved through normal channels.

STEALTH TAXES

• Many people stand to lose part or all of key tax benefits because their income is too high.

• Numerous tax benefits include income-based "phaseout" provisions.

• Among the breaks affected: the phaseout of personal exemptions and limits on many itemized deductions.

• A new report by IRS National Taxpayer Advocate Nina Olson urges Congress to repeal, or at least simplify, phaseouts.

Source: IRS National Taxpayer ReportThe report says more than 60 million individual income-tax returns, about 44% of the total filed last year, are affected each year by one or more of these provisions, which can drive up a taxpayer's marginal tax rate well above his or her official tax rate.

It's doubtful that Congress will eliminate phaseouts. Repealing them would cost the U.S. Treasury Department billions of dollars each year at a time when lawmakers are focusing more on cutting budget deficits than on simplifying the nation's notoriously complex tax system. Yet the report throws a new spotlight on a dimly lit corner of the tax world that many taxpayers need to understand more thoroughly in order to make intelligent tax and investment-planning decisions.

Phaseouts are also referred to as "stealth" taxes because they're difficult for the average taxpayer to detect. Among the most significant: limits on personal exemption amounts and on many itemized deductions, such as charitable contributions and state and local taxes, for taxpayers whose income exceeds certain levels. (More than 5.7 million individual returns for 2004 were hit by the income limit on itemized deductions. As a result, taxpayers were unable to deduct a total of more than $36.7 billion of itemized deductions for that year.)

Other benefits that may be affected include a credit for adopting a child, the child tax credit and education-related incentives. A new deduction for mortgage insurance also has phaseout provisions.

Even sophisticated taxpayers may be unaware of this issue since growing numbers of Americans are paying someone else to do their taxes for them. Last year, more than 60% of all taxpayers used paid preparers, up from 40% in the mid-1980s. And growing numbers of people rely on tax-preparation software to do the number-crunching for them.

"Most of my clients are unaware" of the phaseouts, says Stephen W. DeFilippis, owner of West Suburban Income Tax Service in Wheaton, Ill., and an enrolled agent, which means he is licensed to represent taxpayers before the IRS. He says clients often are amazed their tax bill was significantly higher than expected.

Phaseouts need to be repealed, said Ms. Olson, because they inject "needless complexity" into the tax laws, reduce the effectiveness of tax incentives, and make it tougher for many taxpayers to estimate their tax bills and pay the right amount of withholding or estimated taxes. Also, she argued, they probably reduce overall tax compliance.

"They add quite a bit of complexity to the tax code," agrees Lindy Paull of PricewaterhouseCoopers in Washington. Ms. Paull is a former chief of staff of Congress's Joint Committee on Taxation, which issued a lengthy report in 2001 urging Congress repeal numerous phaseout provisions.

Many phaseouts and other similar provisions affect only upper-income taxpayers, such as the one that applies to personal exemptions. For this year, each personal exemption is a maximum of $3,400, up $100 from 2006. But if your income exceeds a certain level, the most you can claim on your return for 2007 will be $1,133, the IRS says. For a married couple filing jointly, the personal exemption begins to phase out when their income exceeds $234,600 for 2007 and reaches the maximum phaseout amount after $357,100. For most singles, the range is $156,400 to $278,900.

Congress voted to ease this provision starting in 2006, and repeal it entirely in 2010. But nobody knows whether that will happen now that the Democrats have recaptured control of both houses of Congress. Some Democrats say they want to roll back President Bush's tax breaks for higher-income taxpayers.

Other provisions affect people with much less income. For example, there are complex rules for how much of your Social Security benefits may be subject to tax.

Suppose your income -- which, for this purpose, includes such items as tax-exempt interest income and half of your Social Security benefits -- exceeds $32,000 but not more than $44,000. In that case, a maximum of half your Social Security benefits would be reported as part of your adjusted gross income. If your income exceeds $44,000, up to 85% of your Social Security benefits would be included as income and taxed accordingly.

As a result, some lower-income Americans may be paying significantly higher tax rates than they think.

Phaseouts are popular among lawmakers as a revenue-raising device since raising tax rates typically creates much bigger headlines -- and more of a political firestorm -- than tweaking complex phaseouts and other provisions. Thus, it would appear that many stealth taxes are here to stay.

[Tax Chart]

The IRS sets Feb. 3 as the starting date to process returns claiming tax benefits enacted last month.

Congress waited until last month to extend the life of several tax breaks that had expired at the end of 2005. Among the now-resurrected provisions, known as "extenders," is the option for taxpayers who itemize to deduct state and local sales taxes instead of state and local income taxes. Other revived provisions include special deductions for higher-education tuition and fees and for educator expenses.

Any other returns for individuals not claiming the extender provisions can be filed as normal this month, the IRS said.

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questions:

1.) What is a phaseout provision? Based on comments in the article, why are these provisions written into law by Congress?

2.) How many individual tax returns were affected by phaseout provision on itemized deductions in 2004? How many itemized deductions were disallowed for that reason? Based on this information, what was the average amount per return of disallowed deduction?

3.) What are the major deductions that are affected by phaseout provisions?

What is the nature of the phaseout limitation? In your answer, comment on the definitions of adjusted gross income and modified adjusted gross income.

4.) Do you favor retaining or eliminating phaseout provisions in U.S. tax code?

Support your answer.