Tax Trap: How Phaseouts Can Take Away Valuable Breaks

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Most taxpayers try to take advantage of every tax break they can find, and many make plans to arrange their finances to make maximum use of credits, deductions, and other tax breaks. But the tax laws are riddled with traps that often take away tax breaks. One of the most common involves what are known as tax phaseouts: income levels at which tax credits and deductions begin to disappear.

Phaseouts On the Rich

Many of the tax phaseouts that get the most attention are tailored toward taking away tax benefits for high-income taxpayers. For instance, the tax law changes that took effect at the beginning of 2013 reinstated what's known as the Personal Exemption Phaseout, which starts taking away the income reduction for personal exemptions for single taxpayers making more than $250,000 and married taxpayers with income over $300,000. The reduction is 2 percent for every $2,500 above the respective threshold, meaning that those who make $125,000 more than the threshold amount no longer get any benefit from personal exemptions. With personal exemption amounts of $3,950 per person in 2014, big families can lose thousands of dollars in tax breaks because of these phaseout provisions.

Indeed, many phaseouts target taxpayers with relatively high incomes. The Adoption Credit, for instance, begins to phase out at $197,880 of income, and $40,000 above that threshold, it disappears entirely. Similarly, the amount that you're able to exclude from the Alternative Minimum Tax begins to phase out once your income rises above $117,300 for single filers and $156,500 for joint filers, losing $1 for every $4 above the limit until you run out of exemption.

How Phaseouts Can Hurt Lower-Income Taxpayers

But phaseouts don't just target those best able to handle their disappearance. Some of the most draconian phaseout provisions are on tax breaks targeted at low-income taxpayers.

The best example is the Earned Income Tax Credit. This credit gradually rises with income, and once it hits its maximum amount, it stays there for those with children until income reaches $17,830 for single filers or $23,260 for joint filers. Above that level, though, the credit starts to go away. For those with one child, the phaseout rate is about $16 for every $100 of additional income above that threshold. If you have two or more children, the rate jumps to more than $21 for every extra $100 you earn.

Phaseouts therefore have a huge impact on the marginal tax rate that recipients of the Earned Income Tax Credit pay. In addition to the regular 10 percent or 15 percent tax rates that generally apply to those who have incomes in the range eligible for the credit, the phaseout adds 16 to 21 percentage points to their effective marginal tax rate. When you do the math, marginal rates of as much as 36 percent treat low- and middle-income taxpayers the same way the IRS does much higher-income taxpayers beyond those phaseout limits.

Other tax breaks have similar problems. The Child and Dependent Care Credit doesn't entirely disappear, but the amount of the credit gradually drops from 35 percent of the first $3,000 of childcare expenses for those with incomes of $15,000 or less, down to 20 percent for those with incomes of more than $43,000. The Saver's Credit for retirement contributions gives people up to 50 percent back for as much as $2,000 in deposits to IRAs, 401(k)s, or other retirement accounts for single filers earning $18,000 or less or joint filers with income of $36,000 or lower. But that credit drops to 20 percent the moment you earn a single dollar above those limits, with a 10 percent rate applying further up the scale. Once you earn more than $30,000 for singles or $60,000 for joint filers, you lose that 10 percent amount entirely -- again, even if you only exceed it by a single dollar.

How to Deal With Phaseouts

To avoid the traps that phaseout provisions lay out, you have to know in advance what's at stake. Paradoxically, in a few cases, it might make sense to earn less income than you otherwise would in order to avoid the phaseout provision, especially with the Saver's Credit and its particularly abrupt phaseout.

With most phaseouts, earning more income will still leave you with more money in your pocket after taxes. Still, policymakers point to phaseouts as sometimes thwarting the intent of tax breaks designed to help certain taxpayers. Expressing your discontent to those policymakers and the legislators who create tax laws might not help you right away, but it can be one way to get the ball rolling and hopefully effect change in the long run.

Motley Fool contributor Dan Caplinger concentrates on phasing lower taxes in, not out. You can follow him on Twitter @DanCaplinger or on Google+. To read about our favorite high-yielding dividend stocks for any investor, check out our free report.​

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