It seems that we dodged a bullet at the end of the year when the American Taxpayer Relief Act of 2012 spared the charitable deduction. With all the talk during last year’s budget season about limiting the tax benefit to 28% as well as what passed for dialogue during the Presidential campaign about placing overall limits on deductions, the idea that the charitable deduction might be vulnerable in the year-end scramble was not beyond the pale. For now, at least, it’s safe and will continue to function as it has for many years. Life goes on pretty much as before.
Or does it? Lately I’ve been on a tear about the reinstatement of the so-called Pease limitation, which absolutely has an indirect effect on charity. You may remember this little beauty – it was originally enacted during George H.W. Bush’s administration as a way to increase tax without increasing tax rates. It went away for a couple of years courtesy of the tax cuts of the past decade but has now come roaring back with a vengeance as part of ATRA 2012. Effectively, it scales back the itemized deductions of high income taxpayers by 3% of any excess adjusted gross income (AGI) over certain levels. It kicks in once you reach the magic AGI number ($250,000 for singles, $300,000 for married filing jointly). At that point, your itemized deductions, including the deduction for charitable contributions, are dialed back by 3% of the excess income over that threshold amount. (Example – a single individual with $375,000 of AGI would lose up to $3,750 of itemized deductions: $375,000 – $250,000 = $125,000 x 3% = $3,750). This limitation has an effective overall limitation to it – you cannot lose more than 80% of your total deduction.
This limitation has always galled me. It flies in the face of fairness and transparency to the point that it is almost impossible to determine your tax. It effectively adds up to 1.2% to the ordinary tax rate. Think of it this way – a top bracket taxpayer who is subject to the “Pease limitation” earns an additional $1,000. His itemized deductions will be reduced by 3% of that $1,000, or $30. This reduction in deductions is essentially an increase in income – his increase in overall taxable income will be $1,030. Multiply that additional taxable income by 39.6% to get the additional tax of $408. $408 divided by $1,000 is equal to 40.8%, which is 1.2% higher than the stated top rate of 39.6%.
But wait, there’s more!….
- Combine this haircut along with the Obamacare tax on “excess” earnings of .9% and the top rate is further increased to 41.7% for earned income. In our example, the marginal tax would be $417 instead of $408;
- If the marginally generated income is actually net investment income rather than earnings, the situation is worse – the top tax rate on investment income rises to 44.6%, or $446 in our example;
- And we haven’t even touched the phaseout of personal exemptions or the alternative minimum tax (AMT) yet!
But let’s put this monster into perspective. It comes into play ONLY with INCREASES IN INCOME. It has nothing to do with INCREASES IN DEDUCTIONS. So the argument that charitable contributions will suffer because of the limitation itself is misguided. Think of it this way – if income is held constant, each and every dollar of allowable charitable contribution will reduce taxable income by one dollar. If my income is $X and I am in the 39.6% tax bracket and I decide to make a $10,000 to my JCF donor advised fund on December 31, 2013, I will save $3,960 in federal income tax. Period. Assuming that my charitable contributions are not constrained by the income limitation rules that have long existed for these deductions, I don’t lose ANY value of the additional deduction because of an increase in deductions. However, if my income increases, I absolutely will lose the benefit of some of my deductions because of the “Pease limitation.” The decision to increase or decrease charitable contributions or any other deductible expenses can and should be made independently of the decision to increase or decrease taxable income.
The bottom line is that additional deductions will always do you some good in saving taxes while additional income may end up being taxed at a rate higher than you would like. Decisions about one versus the other should be made independently of one another.