It doesn’t seem right but sometimes you actually lose more money when you make more money. That is just the way our tax code works and the last thing you want is to be caught off guard when it happens. Most people think that it is always better to have higher income because we don’t have a 100% income tax rate on earned income. With every dollar you earn, even at the highest federal tax rate of 35% and combined state and local income tax rate of 12.7%in New York City, you are still “only” paying just under half of your income in taxes. You’d still get to keep a little over half of what you made.
However, that is not always true. When high income taxpayers hit certain thresholds in adjusted gross income, they lose the ability to take some deductions. In some cases, earning $10,000 more can cause the IRS to disallow more than twice that much in deductions, so essentially you make a dollar and then lose two. You put your heart and soul into your job to help your company get ahead and to help your career, only to lose money doing it. It could actually be in your best interest not to take the bonus.A great example is passive losses on rental real estate property, and this one is a thorn in my side as it affects me personally. Once your adjusted gross income is over $150k, the IRS only allows you to take your real estate losses of up to $25,000 – such as depreciation, association dues, mortgage interest, property taxes, maintenance etc. – against passive income such as your rental income. Any losses above and beyond the gains must be “carried forward” to future years, either when you sell it or when your income is below the threshold. So in other words, the rental loss is just about useless in the current year. If your adjusted gross income is $151,000, you may be shut out of any rental deductions for your current tax return and you just have to hope you can use them in the future.
Here are some income levels where deductions were recently phased out and will have an impact on married taxpayers that file jointly in 2012:
Deduction phase out ranges
|Tuition and fee deductions||Only applicable if modified AGI did not exceed $80,000 for single filers or $160,000 for joint filers in 2011 (deduction may not be available at all for 2012 tax year)|
|Student loan interest||Modified AGI phased out between $60,000-$75,000 for single filers or $125,000-$155,000 for joint filers in 2012|
|Education savings bond interest||$72,850 to $87,850 for single and $109,250 to $139,250 for married filing jointly|
|Lifetime learning credit||$52,000 to $62,000 for single filers and $104,000 to $124,000 for joint filers|
|American Opportunity Credit||$80,000 to $90,000 (or $160,000 to $180,000 for joint filers)|
|Coverdell Education Savings Account||Phase out ranges from modified AGI of $95,000-$110,000 for single filers and $190,000-$220,000 for joint tax returns|
|Child tax credit||Phase out starts at $55,000 for married couples filing separately; $75,000 for single filers ($110,000 for married filing jointly)|
|Traditional IRA deductions for active retirement plan participants||Single: $58,000-$68,000Married filing jointly: $92,000-$112,000Married filing separately: $0 -$10,000Spousal IRA: $173,000-$183,000|
|Roth IRA contributions||$110,000 to $125,000 for single filers and $173,000 to $183,000 for joint filers|
|Adoption credit||$189,710 to $229,710|
|Passive losses on rental income||$150,000 ($25,000 rental real estate exception decreases by $0.50 for every dollar over $100,000)|
So if your adjusted gross income is over $160k, you just lost out on the tuition deduction, child credits, student loan interest, rental real estate deduction and a lot more. It could get worse going forward with the federal deficit running at$1 trillion for the fourth straight year, making our total national debt over $16 trillion dollars. Something has to be done and both parties target high income earners to pay more either by raising the top tax rates or by reducing deductions allowed.
If you are on the edge of making too much to take advantage of valuable tax deductions, what can you do about it? Here are some strategies to consider:
- Take the pain every other year. Delay your bonus into the following year if you are close to a threshold. This way you have high income every other year and you may be able to take the deductions on your “low” years. This is a strategy I used in 2010. Because my company was flexible in the timing of annual bonuses, I was able to take a 2009 bonus in early 2010 and then took the 2010 year- end bonus in the same year. This helped me to become eligible for some deductions on my 2009 taxes.
- Max out all your pre-tax options such as your pre-tax 401(k) plan for a maximum of $17,000 in 2012 (going up to $17,500 in 2013) and if you are over 50, you can do an additional $5,500. Use your flexible spending account ($2,500 limit in 2013) or health savings account ($3,250 for single plans and $6,450 for family plans in 2013) to pay for your out-of-pocket medical costs on a pre-tax basis. It doesn’t seem like a lot but if when you add the two up, you can reduce your taxable income by $20,000 or more.
- Defer your compensation. Take advantage of executive deferred compensation plans your employer offers and put your bonus in this plan instead. With deferred comp, you have to select your deferral amount before the beginning of the year so you’d need to plan for next year. Also similar to a 401(k), the funds are withdrawn as ordinary income but the similarity ends in that deferred comp funds are treated as assets of the company instead of the employee. If a company went bankrupt, the executive’s funds are at risk.
- Ask for paid time off instead. Instead of taking a bonus, negotiate for more vacation time instead. Imagine taking two weeks off every quarter to spend with your family or simply to recharge and regroup. If you are losing deductions by making more, instead get the best of both worlds by gaining more benefits instead. Think of it as a regular sabbatical.
- Take the bonus. If you are a two income household, take the bonus but take a step back and examine your joint goals. Maybe one of you is more career oriented than the other, and would like to work less or start a business.
If your bonuses end up helping the IRS more than they are helping you, consider alternatives. Look for ways to defer the income in pre-tax plans or deferred comp, time it so you have lower income earning years where your deductions can hit instead of “carrying forward” each year, or look for alternatives that may enhance your life even more. More isn’t necessarily always better.