Thursday, March 1, 2007

Phaseouts: sharp boundary

Phaseout is the process of decreasing some tax benefits, usually based on an increase in income. This can take the form of reducing the amount of a specific deduction, or to decrease some tax credit.

Phaseouts can take different form, the simplest form is a sharp boundary: if your income exceeds a threshold, then some deduction or credit is no more allowed. This form of phaseout is easy to describe and understand but has unwelcome consequences: it introduces a discontinuity in the tax equation. Most of the phaseouts defined by the IRS have a more elegant form that will examine in a future article, but unfortunately a few sharp boundaries do exist in the tax code.

But why is continuity of the tax curve important? Because otherwise small changes in income can create large changes in tax liability. This can be illustrated by the following scenario: John Tuition has carefully entered all the needed information in some tax preparation software, its total tax comes to X dollars. A little later, he receives an updated 1099 form, where after correction its income increases by $10. No sweat, John opens the saved tax file, updates the relevant field, and sees his tax liability jump by $500!! While unlikely, this scenario is not impossible and obviously rather disturbing

The problem is that John was deducting tuition fees. The phaseout for tuition expenses as defined in Chapter 6 of Publication 970 (2006) goes like this (in the typical IRS verbal description)

If your modified adjusted gross income (MAGI) is not more than $65,000 ($130,000 if you are married filing jointly), your maximum tuition and fees deduction is $4,000. If your MAGI is larger than $65,000 ($130,000), but is not more than $80,000 ($160,000 if you are married filing jointly), your maximum deduction is $2,000. No tuition and fees deduction is allowed if your MAGI is larger than $80,000 ($160,000).

So the phaseout has two sharp boundaries that depend on your filing status. If you cross a boundary, the deduction may decrease by $2,000, as it happened to John. The increase in tax liability is the $2,000 step multiplied by the marginal tax rate, 25% for incomes close to the boundary. So John may have reasons to curse who wrote that tax provision, but calling the customer support for the tax preparation software will be fruitless.

And things can go even worse. The increase in tax liability may cascade because this could result in John crossing an other sharp boundary. The IRS starts to assess penalties for underpayment of estimated tax based on a sharp boundary. The underpayment rules are a model of complexity that I may tackle in more detail later on, but the boundary is defined for most people like this in Chapter 4 of Publication 505 (for 2005, no change in 2005 as far as I know)

In general, you may owe a penalty for 2005 if the total of your withholding and estimated tax payments did not equal at least the smaller of:
1. 90% of your 2005 tax, or
2. 100% of your 2004 tax. (Your 2004 tax return must cover a 12-month period.)

So the $10 increase in John's income can result in an increase of about $500 in tax liability. That increase can possibly trigger the estimated tax underpayment penalty. Calculating the underpayment penalty is complex, in general you let the IRS figure that out, but it will be a positive value :-). If anybody can provide an estimate for the above scenario, that would be great.

Hopefully the bad consequences of sharp phaseout boundaries are now clear, and the tax code has a solution, tapered phaseouts, with less drastic impact on the tax equation. This will be the subject of the next article

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