How often do you get a haircut? On average, I get a haircut every two weeks. If I don't get a haircut regularly, I start to look funny. Although the frequency with which you visit the barber or hair salon is at your discretion, if you are a high-income taxpayer, you might be getting an extra haircut in 2013 that you didn't know about. As a part of the new tax laws implemented at the end of 2012, the IRS will be giving high-income taxpayers their own haircut through the provisions known as PEP and Pease. This refers to the phaseout of personal exemptions (PEP) and certain itemized deductions (Pease) when adjusted gross income (AGI) reaches a certain amount. The AGI limit is different based on your filing status, which can be Single (S), Head of Household (HOH), or Married Filing Jointly (MFJ).
Personal exemptions
Personal exemptions are allowed to reduce adjusted gross income (AGI) in arriving at taxable income. Taxpayers typically receive one exemption for themselves, their spouse, and dependents. For instance, if you are a married taxpayer with two dependent children, you are allowed four personal exemptions.
The personal exemption amount for 2013 has been set at $3,900. However, the exemption amount will begin to phase out when AGI reaches $250,000 (S) / $275,000 (HOH) / $300,000 (MFJ) and phases out completely at $372,500 (S) / $397,500 (HOH) / $422,500 (MFJ). The exemption is reduced by 2% for every $2,500 over the AGI limit.
Example: Bonnie and Clyde are married taxpayers with three children. Their AGI is $330,000 and their personal exemption amount is $19,500. Their AGI exceeds the limit by $30,000 and therefore their personal exemptions are reduced by $4,680 ($30,000 / $2,500 x 2% x $19,500).
Itemized deductions
Itemized deductions consist of specific expense items that are permitted to be deducted on an individual tax return, the most common of which are medical expenses, state taxes paid, charitable contributions, and mortgage interest.
Itemized deductions will be limited when AGI reaches $250,000 (S) / $275,000 (HOH) / $300,000 (MFJ). When these limits are reached, itemized deductions will be reduced by an amount equal to the lesser of 1) 3% of AGI or 2) 80% of certain itemized deductions. All itemized deductions are subject to the 80% calculation except for qualified medical expenses, interest expense, and casualty/theft losses.
Example: Bob is a single, unmarried doctor. His AGI is $285,000 and he has total itemized deductions of $50,000. Of these deductions, $10,000 is interest expense. His itemized deductions are therefore reduced by $8,550, which is the lesser of 3% of his AGI ($285,000 x 3% = $8,550) and 80% of certain itemized deductions (($50,000 total itemized deductions - $10,000 interest expense) x 80% = $32,000).
Conclusion
If you are a high-income taxpayer, you will most likely be affected by one or both of these provisions. There are still 3 months left in the year, which is plenty of time to consult a tax professional on ways to reduce the impact of the PEP and Pease on your individual situation. This will ensure that the only haircut you have to worry about is the one you get every two weeks.