Pass the PEP, Pease?

November 12, 2013

No, I am not asking you to pass me the pepper. PEP stands for personal exemption phaseout, a potential reduction or even elimination of the $3,900 per person exemption on your 2013 tax return. For single filers with adjusted gross income (AGI) in excess of $250,000 or couples who are married filing jointly and have AGI in excess of $300,000 the exemption will be reduced by 2% for every $2,500 of AGI (or portion thereof) above $250,000 ($300,000 for married couples filing jointly). For married couples, personal exemptions will be fully phased out once their AGI exceeds $422,500, or for single filers if AGI exceeds $372,500 according to Internal Revenue Bulletin 2013-5.

The “Pease” limitation, named for the legislator who sponsored the rule, is the phaseout of itemized deductions, which could raise your tax bill if you are a higher income earner by reducing the tax benefit of your mortgage interest, state income or sales tax, charitable contributions, and certain other itemized deductions. The Pease limitation reduces the value of your itemized deductions by 3% of the AGI above $300,000 for couples, and $250,000 for single filers—to a maximum reduction of 80% in value. Itemized deductions for certain medical expenses, investment interest, and for casualty, theft, or gambling losses are exempt from this phaseout.

Let’s look at a hypothetical scenario provided by Fidelity’s 2013 Taxpayer’s Guide:

Say a married couple, Jim and Erica, claim $25,000 in itemized deductions for mortgage interest and state taxes and claim a combined $7,800 in personal exemptions. The new phaseout schedule will reduce the tax benefit of those deductions based on their earnings. If their AGI was $250,000, putting them in the 33% bracket, they could claim the full amount of their itemized deductions and personal exemptions, resulting in a combined benefit of $10,824. But what if their AGI was $440,000? That would put them in the 35% tax bracket and their exemptions and itemized deductions would have been worth $11,480. But because of the PEP and Pease phaseouts, their personal exemptions would have been fully phased out and their itemized deductions would have been reduced by $4,200 (3% x $140,000). As a result, the tax benefit of their deductions would be only $7,280.

If you could potentially be impacted by the PEP or Pease limitation, there is still time before the end of the year to reduce your AGI to help minimize these phaseouts:

  • Max out your 401(k) with pre-tax deferrals to the $17,500 limit.  If you are age 50 or older, take advantage of the additional $5,500 catch-up contribution.  Keep in mind that Roth 401(k) deferrals do NOT reduce your AGI.
  • Contribute to your HSA if you are eligible.  If you have a high deductible health plan with individual coverage, the maximum both you and your employer can contribute is $3,250 and if you have family coverage the maximum is $6,450.  More details can be found in IRS Publication 969.
  • Harvest any losses you may have on investments.  You can take a capital loss of up to $3,000 against your gross income per year and carry the rest forward indefinitely.
  • Make those needed repairs on any rental properties you may own to offset any rental real estate income.

So the next time you ask for the pepper shaker, think of PEP and Pease.