The Limbo Strategy to Saving Taxes

by Kathy M. Kristof | Mar 9, 2009 | Comments

Key Stats

• History: Federal tax phase-outs gained steam in the early ’90s, as a way to give tax breaks without seeming to give too much to the wealthy.
• Where to spot help: Lines 23-34 on Form 1040 show most above-the-line deductions. For additional information about them, download Publication 17 from the IRS . 
• Recent news: The American Recovery and Reinvestment Act of 2009 (aka the stimulus law) created or revised seven income-tested tax breaks for individuals, according to H&R Block. President Obama’s  budget proposes even more.
• The work-around: Usually, your AGI triggers the phase-outs, but you may be able to reduce AGI with above-the-line deductions.

Most days, being well-off is preferable to not being well-off. Not on April 15. That’s the day that anyone with what’s deemed a high income is left out in the cold while everyone else has a tax-deduction party. The usual mechanisms for this exclusion are what’s known as “phase-outs.” Once your adjusted gross income (AGI) exceeds certain thresholds, you start losing some deductions and credits; at some level of income, the write-offs evaporate entirely. It’s too late to beat the phase-outs for your 2008 taxes. But you may be able to skirt them for your ’09 taxes and beyond by taking advantage of “above-the-line” deductions that can let you limbo under the income thresholds. If you’re in the sweet spot — singles earning $75,000 to $100,000 and couples earning as much as $200,000 — learning to stay under the thresholds can save you a small fortune in taxes.

The Major Phase-Outs

The list of tax breaks that phase out at certain levels of adjusted gross income is long and growing — 25 at last count, says Mark Luscombe, principal tax analyst with CCH Inc., a Riverwoods, Ill.-based publisher of tax information.

Some of the most significant on 2008 returns and beyond:

• Child tax credit of $1,000 per dependent under age 17 starts to phase out at $75,000 for singles, $150,000 for married couples
• Hope tax credit to finance college bills of a freshman or sophomore starts to phase out at $48,000 for singles, $96,000 for couples
• Lifetime learning credit for education expenses starts to phase out at $48,000 for singles, $96,000 for couples
• Tuition and fees deduction, which can reduce taxable income by up to $4,000, begins to phase out at $65,000 for singles, $130,000 for couples

New phase-outs for 2009 returns:

• First-time homebuyer tax credit of $8,000 begins to phase out at $75,000 for singles, $150,000 for couples
• Adoption tax credit starts to phase out for both singles and married couples at $174,730 in income
• American Opportunity tax credit of up to $2,500 per college student starts to phase out at $80,000 for singles, $160,000 for couples
• Making Work Pay tax credit starts to phase out at $75,000 for singles, $150,000 for couples
• Vehicle purchase deduction, to offset sales taxes on new cars bought in 2009, starts to phase out at $125,000 for singles and couples

Avoid the Phase-Outs

There’s really only one way around the phase-outs: to reduce your adjusted gross income enough that you dive under the phase-out thresholds. Other than earning less money — not recommended — the only strategy is to claim the most you can in above-the-line deductions. They range from self-employment retirement plan savings to rental-income expenses, and they work because, unlike most deductions, they’re subtracted before adjusted gross income is calculated. The more you can hack away at your income above the line the more you can drive your AGI below the phase-out thresholds and increase your write-offs.

Here’s how to do it:

• Save for retirement in a tax-favored plan. You can set aside up to $16,500 a year (more if you are 50 or older) in an employer-sponsored retirement plan, such as a 401(k) or 403(b). We know, we know. You never want to put another penny in a plan that can lose 50 percent in a year. Well, you don’t have to put the money in stock funds, and you can still get the above-the-line write-off. The self-employed can save up to 25 percent of their self-employment income each year, or $46,000.
• Use your employer’s pretax plan for child care or health care expenses. A dependent care account might let you set aside up to $5,000 annually to pay for a nanny, preschool, or summer day care. A health savings account allows you to save for medical bills that aren’t covered by insurance, such as orthodontia and elective surgery. Let’s say you and your working spouse earn $140,000 in joint income and have $8,500 in day-care bills plus unreimbursed medical expenses such as deductibles and orthodontia. Pay the $8,500 through pretax savings accounts and you cut your adjusted gross income from $140,000 to $131,500.

Assuming a 30 percent marginal tax bracket, a couple who paid for day care and health expenses through tax-advantaged accounts (qualifying them, too, for $5,000 in income-tested child tax credits) and saved $11,000 apiece in employer-sponsored savings plans could save $10,650 in taxes by bringing their AGI below the thresholds for key tax breaks.