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How Bunching Can Preserve Your Right to
Itemize
Tax laws are at times nothing if not infuriating. Indeed,
with phase-outs and sunsets coming and going, taxpayers may find
it difficult planning from one year to the next.
Case in point: In 2006 and 2007, the overall limitation on
itemized deductions that reduces the value of certain itemized
deductions claimed by upper-income individuals is scheduled to
be phased out.
In effect, higher income individuals will have a small tax
rate reduction, according to PricewaterhouseCoopers 2007 Guide
to Tax and Financial Planning.
By way of history, the tax law limits the amount of certain
itemized deductions that individuals can use to reduce their
taxable income. For instance, miscellaneous deductions are
limited to those in excess of 2 percent of Adjusted Gross Income
or AGI.
But Congress has also placed what's called an
"overall" limitation on the deductibility of itemized
deductions, according to The Ernst & Young Tax Guide 2006.
For 2007, the total of this group of deductions must be reduced
by 2 percent (down from 3 percent) of the amount of your AGI in
excess of $156,400 for married couples filing jointly and
$78,200 for married filing separately. Itemized deductions will,
however, never be reduced by more than 80 percent of the amount
by which they exceed a specified group of deductions, including,
but not limited to, medical expenses, investment interest, and
theft losses.
This reduction in itemized deductions is applied after the
taxpayer has used any other limitations that exist such as the
AGI limitation for charitable contributions and miscellaneous
itemized deductions. The reduction falls to 1 percent in 2008
and 2009 and is phased out in 2010. Medical expenses, casualty
and theft losses, investment interest expense, and gambling
losses are not subject to this rule, insofar as calculating the
80 percent limitation is concerned, according to the Ernst &
Young Tax Guide.
So what happens to taxpayers who for whatever reason (a
bonus, a salary increase, or new job) will find themselves
losing their ability to use itemized deductions fully in 2008?
What kind of planning can they do in 2007?
Among other things, taxpayers may want to consider a
technique called "bunching," otherwise accelerating or
deferring itemized deductions where possible. Bunching may work
if the taxpayer is able to accumulate deductions so that they
are high in one year and low in the next.
According to Deloitte Tax's Essential Tax and Wealth Planning
Guide, taxpayers should explore opportunities to time deductions
for charitable contributions, state and local taxes, and other
payments within the taxpayer's control. In some cases, it may be
better to take deductions in the current tax year; the caveat
emptor of this strategy is Alternative Minimum Tax or AMT.
For instance, if the taxpayer isn't subject to AMT in 2007,
they should consider paying 2008 real estate and property taxes
before year-end. Also, the taxpayer might consider paying any
remaining state and local estimated income tax payments before
the end of the year. State and local taxes are not deductible
for AMT purposes, so taxpayers should consider the consequences
of AMT before bunching these or other "non-deductible for
AMT" itemized deductions in one year.
In another example, taxpayers might also accelerate mortgage
payments. According to Deloitte, cash-basis taxpayers can, in
most cases, deduct expenses in the year paid. Thus prepayment of
mortgages due in 2008 may provide a deduction for interest to
2007.
According to Ernst & Young's Tax Guide, in certain
situations, it's possible for the 2 percent limitation to reduce
allowable itemized deductions below the standard deduction.
Thus, it's worth considering this possibility when choosing
whether to itemize or not.
Taxpayers contemplating bunching should read the Instructions
for Schedules A & B for Form 1040, which is available on the
IRS' web site at www.irs.gov.
In order to make sure that the strategy of bunching deductions
makes sense in your particular situation, it is generally a good
idea to consult with a tax professional before proceeding. At
the very least it is important that you are comfortable using
tax planning software and are capable of identifying all of the
ramifications of any tax planning technique.
March 2007 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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