Itemized deductions... what a lovely pairing of words. Itemized deductions are a method by which you can pay for qualified medical, tax, interest, charitable, and other miscellaneous expenses, and receive a tax deduction. It's certainly a beautiful thing.

Many people think, regardless of their income, that itemized deductions will always help reduce their taxes. They cling to their itemized deductions as tightly as Linus clung to his blanket in the Peanuts comic strip.

Well, I'm here to tell you that you might not get as much "bang for the buck" from those itemized deductions if your income is above certain levels. This is simply another method Uncle Sammy uses to generate more tax revenue without raising the general tax rates.

There is a section in the tax code that limits the amount of itemized deductions allowed to certain "high-income" taxpayers. The limit will apply to you (regardless of whether you believe you're a "high-income" taxpayer or not) if your adjusted gross income (AGI) exceeds $137,300 ($68,650 for a separate return filed by a married individual) for tax year 2002. The good news is that this AGI limitation is "indexed" for inflation each year. So, while the AGI limitation is $137,300 for 2002, it'll be a bit higher for 2003. Before we go too far, please note that the 2002 limitation is $137,300 and is applicable for both married folks filing a joint return and single folks. It might not seem fair, but that's the way it works.

In fact, many taxpayer have railed against this "hidden tax" for many years. And it finally must have hit a responsive chord. With the passage of The Economic Growth and Tax Relief Reconciliation Act of 2001, changes were finally made. The new law allows that in 2006 through 2009 tax years, the 3% limitation is reduced (two-thirds in 2006 and 2007 tax years, one-third in the 2008 and 2009 tax years). The 3% limitation will be completely eliminated beginning in the 2010 tax year. So if you're a high-bracket taxpayer and you live long enough, you just might see some relief from this tax provision.

Nevertheless, if you are subject to this limitation in 2003 to 2005, you're required to reduce the overall amount of your allowable itemized deductions by the lesser of:

• 3% of the excess of adjusted gross income over the applicable amount, or
• 80% of the amount of otherwise allowable itemized deductions.

Of course, to make things complicated, this limit doesn't apply to all deductions.

Deductions subject to the overall limit:

• Taxes paid
• Interest (except investment interest)
• Charitable contributions
• Job expenses
• Most miscellaneous deductions

Deductions not subject to the overall limit:

• Medical (and dental) expenses
• Investment interest expense
• Non-business casualty and theft loss
• Gambling loss (to the extent of gambling winnings)

Now, please don't confuse the above limitations with the "normal" limitations that you are likely familiar with. For example, there's a 7.5% threshold for medical deductions, a 10% floor for casualty losses, and a 2% floor for miscellaneous deductions. The floors are based on the specific percentage of AGI.

Example of "normal" deduction limitations: Carole has an AGI of $40,000 for 2002. Her floor for miscellaneous deductions is 2%. This means that she can only deduct qualifying items that exceed 2% of $40,000, or $800. If she has $700 in miscellaneous deductions, she's out of luck. If she has $900 in miscellaneous deductions, she can deduct $100 -- the amount by which the deductions exceed the floor.

As you can see, the hurdle is higher for medical deductions. Carole will only be able to deduct medical expenses that exceed 7.5% of her AGI -- in her case, $3,000.

But, the "overall" limits for high-income taxpayers discussed above are in addition to any specific floors for medical deductions or miscellaneous itemized deductions.

Example of overall itemized deduction limitations: Let's look at a brand-new example for Carole. Let's assume Carole is still single, but her AGI is much higher -- $175,000 for 2002 -- and Carole has the following itemized deductions:

• Medical (after the 7.5% floor, which means that she has $15,625 in total medical expenses, but only the excess over her 7.5% AGI floor will be deductible): $2,500
• Taxes: $3,100
• Home mortgage interest: $19,500
• Investment interest: $1,200
• Charity: $4,000
• Miscellaneous itemized deductions (after the 2% floor, which means that she has $4,000 in total miscellaneous deductions, but only the excess over her 2% floor will be deductible): $500

You might think that Carole's total itemized deductions would amount to $30,800 — the grand total of all of the itemized deductions noted above. And, sadly, you would be very wrong. Because Carole is deemed a "high-income" taxpayer, with AGI greater than $137,300 for 2002, her itemized deductions will be limited. How can Carole determine how many of her itemized deductions will be snatched from her? Well, she can use this formula (and so can you, if you think that your AGI will be above the limitation noted):

1. Add your total itemized deductions. In Carole's case, that would be $30,800.
2. Add your itemized deductions for medical, investment interest, casualty losses, and any gambling losses. For Carole, this would amount to $3,700 ($2,500 for Medical and $1,200 for investment interest).
3. Subtract line 2 from line 1. For Carole, this would be $27,100.
4. Multiply the result you got in line 3 by 0.8 to find 80% of the total. Carole's computation would give a result of $21,680.
5. Note your adjusted gross income. Carole's AGI is $175,000.
6. Note the AGI limitation. As we told you above, the AGI limitation for 2002 is $137,300, which is the year we're using for this example.
7. Subtract line 6 from line 5 to determine how much your AGI exceeds the limitation amount. This gives Carole a result of $37,700.
8. Multiply line 7 by 0.03 to find 3% of the result. Carole's result is $1,131.
9. Enter the smaller of line 4 or line 8. For Carole, line 8 is smaller, so she enters $1,131.
10. Subtract line 9 from line 1. For Carole, this gives her a result of $29,669. This is the allowable amount of all of Carole's itemized deductions for 2002.

So, bottom line, Carole lost $1,131 of her itemized deductions for 2002. Assuming that Carole is in the 30% tax bracket (which she would be, given only this information), this reduction in itemized deductions will cost her an additional $339 in federal taxes ($1,131 x 0.30 = $339.30).

The bad news just keeps on coming: Many states also similarly limit itemized deductions for high-income taxpayers. So Carole also could be slapped around by her state tax agency. Ouch!

When we say the itemized deductions are lost, we mean lost. There are no provisions to carry these lost deductions over to any future or prior tax years, even if your income was much lower in any of those years. They are simply gone forever — just like you never had the deduction. Many very-high-income individuals can see their itemized deductions slashed by as much as 80%. Others, such as Carole, will just get a punch to the kidney.

What could Carole have done to avoid this? About the only thing possible would have been to control her income to remain under the $137,300 limitation. For many of you, this might be possible. For other folks who realize a large portion of their AGI in wages or other "fixed" income, it may be impossible. And, for those unfortunate taxpayers, all they can really do is search for a large bullet to bite.

So, if your AGI is above the limit, you'll lose your grip on some of your itemized deductions. Don't be caught by surprise. For more information on overall deduction limitations, check out IRS Publication 17 and also in the instructions for Form 1040, Schedule A.

Related Links:
Internal Revenue Service

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

June 14, 2002

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