[Updated for 2015 levels] While legislation to avert the fiscal cliff enabled federal tax rates for most Americans to stay constant, it raised the threshold for those required to pay higher tax rates to $400,000/$450,000 (single/married) and included provisions to restart limits on certain itemized deductions and personal exemptions that were phased out and eventually removed as part of the extended Bush-era tax cuts. PEP and Pease were the two provisions in the tax code that increase taxable income for high-income earners. PEP is the phaseout of the personal exemption and Pease (named after former Senator Donald Pease) reduces the value of most itemized deductions once a taxpayer’s adjusted gross income (AGI) reaches a certain point.
But the definition of higher income thresholds for these provisions is much lower than the one used for higher federal tax rates and so will apply to a lot more people. The adjusted gross income (AGI) thresholds are: $258,250 (single filers), $309,900 (married joint-filing couples), $284,050 (heads of households), and $156,000 (married filing separately). These limits are tied to official CPI measures and hence are adjusted for inflation every year.
The re-instituted phase-out limitation on itemized deductions cuts the amount of deductions you can take by 3% of adjusted gross income (AGI) above the specified thresholds but you cannot lose more than 80% of the affected itemized deductions. This means that tax payers whose AGI is greater than the specified income thresholds won’t be able to take all of the deductions associated with items like home mortgage interest, charitable donations and state/local income tax payments. While a lot of itemized deductions are affected by the itemized deduction limitation, some such as medical expenses, investment interest and gambling losses are not subject to the limit.
For an example of the above consider a married couple with income of $400,000 who file their tax return with $50,000 in itemized deductions. This couple is $100,000+ above the itemized deduction AGI threshold meaning that their allowed deductions would be reduced —potentially adding to their tax liability by about $1,000.
You are allowed to deduct the personal exemption for yourself, your spouse, and your eligible dependents. The IRS estimated the personal exemption was worth $3,800 on average under 2012 rules. But with the new Personal Exemption Phase-out (PEP) the value of each personal exemption is reduced from its full value by 2 percent for each $2,500 above the above specified income thresholds.
What This Means For You
If your AGI is below the above thresholds then you should see no impact from the above changes and can claim your personal exemptions and itemized deductions as you normally would. Higher income taxpayers though will face reductions and likely see higher tax bills in 2013 as the value of their personal exemptions and itemized deductions are reduced.