Dollar bills floating over U.S. Capitol © Corbis

Two of the lesser-known and least-understood provisions of the fiscal cliff legislation will raise taxes on high-income taxpayers by phasing out personal exemptions and the amount of itemized deductions wealthy taxpayers are allowed in 2013.

The set of rules, dubbed personal exemption phaseout and Pease (named after former U.S. Rep. Donald Pease, D-Ohio,  who helped create it), were originally passed in the early 1990s, and remained in place until the Bush-era tax cuts of 2001 gradually eliminated them. The new fiscal cliff bill restores the limitations in 2013. By limiting the number of exemptions and deductions a high-income taxpayer is allowed, the taxes effectively raise a filer's taxable income.

The fiscal cliff deal raised federal income taxes on married households who earn more than $450,000, or single filers who earn more than $400,000, but the new PEP and Pease limits on the value of personal exemptions and itemized deductions apply for married taxpayers who earn $300,000 or $250,000 for single filers.

"It's a sneaky rate increase once you get above the thresholds," says Matthew LePley, a tax manager at Brighton Jones.

While taxpayers will not have to deal with the tax changes this filing season, experts recommend planning ahead, as a number of tax-saving strategies can be put into action now.

Personal exemption phaseout

Beginning in 2013, the personal exemption phaseout limits the value of personal exemptions for taxpayers who earn more than $300,000 (married filing jointly), or $250,000 (single) by 2% for each $2,500 earned above the thresholds.

The personal exemption, or the amount of income the IRS designates as "exempt" from being taxed at the federal level, is indexed for inflation, so the personal exemption amount is $3,800 for 2012, and rises to $3,900 in 2013.

On their 2013 tax return, for example, a married couple with two children earning $425,000, or $125,000 over the threshold, would lose 100% of their personal deductions ($125,000/$2,500 = 50 and 50 x 0.02 = 1, for a 100% loss). Assuming one spouse doesn't earn, the household would lose all four personal exemptions of $3,900 each, adding up to a $15,600 increase in taxable income for the 2013 tax year.

Using that same scenario, a family of four who earns $375,000, or $75,000 over the threshold, would lose only 60% of their allowable personal exemptions, or $9,360, leaving the family with a deduction of $6,240.

"If you make that kind of money, you will not be allowed to take all of your itemized deductions, and your personal exemptions also will be reduced," said Harvey Frutkin, senior counsel at Frutkin Law Firm. "The impact will be pretty significant."

Pease limitations

For the 2013 tax year, the Pease limitations cap deductions on everything from state taxes to mortgage interest to charitable deductions for tax filers who earn more than $250,000 (single) or $300,000 (married, filing jointly). A recent JPMorgan Chase note to clients estimated this rule will result in a tax hike of about 1.2% for taxpayers who live in states with high income taxes.

The restored limits reduce allowable deductions and can be calculated two ways: either 3% of adjusted gross income above the threshold, or 80% of the amount of the itemized deductions allowable for the taxable year -- whichever calculation lets a taxpayer deduct a higher amount is the one they'll want to use. For most high-income earners, the 3% calculation gives them the highest deduction.

For example, assume a married couple has an adjusted gross income of $500,000 ($200,000 over the limit) and total itemized deductions of $45,000. The deductions are broken down as follows:

  • Mortgage interest deduction: $10,000.
  • Charitable deduction: $20,000.
  • State income tax deduction: $10,000.
  • Property tax deduction: $5,000.

By using the 3% deduction calculation (3% x $200,000), the couple's itemized deductions would be reduced by $6,000, leaving a total deduction of $39,000.

On the other hand, using the calculation of 80% of the total itemized deductions would reduce the couple's itemized deductions by $36,000, leaving a deduction of only $9,000.

Since the first option is the lesser of the two limitations, the couple's deductions would be reduced to $39,000.

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