TAX ADVICE from Julian Block

Julian Blockrenowned tax advisor and Larchmont neighbor, Julian Block, provides help for Gazette readers


Stealth Taxes Eliminated, Eventually

by Julian Block

(July 3, 2003) A centerpiece of the 2001 tax act was the conversion of the five-bracket structure that began at 15 percent and went as high as 39.6 percent into one with six brackets. President Bush and Congress cut a deal for an eventual decrease in the tax rates to 10, 15, 25, 28, 33 and 35 percent.

Fast forward to 2003. The president garnered enough support on Capitol Hill to move into 2003 those lower rates enacted in 2001 that were not scheduled to go into effect until later in this decade. The 2003 act reduces the rates for 2003 to 10, 15, 25, 28, 33 and 35, retroactive to the start of 2003.

More than 90 percent of the households in the country are dunned for taxes at the three lowest rates of 10, 15 and 25 percent. But what of those who are taxed at the three highest rates of 28, 33 and 35 percent? They should know that these official rates frequently are less than the true top rates for millions of upper-middle and high-income individuals.

Their marginal rates are boosted by cleverly concealed tax hikes that went on the books in 1991, during the senior Bush’s presidency. These measures were immediately labeled stealth, or backdoor, tax hikes because their effect is to exact more taxes without raising rates.

"Double Whammy" on the Affluent

They work their mischief with a double whammy on affluent individuals who are deemed to be undeserving as their AGIs (adjusted gross incomes) are above specified amounts. First, their dependency exemptions are phased out, that is, gradually reduced. Second, there is a limitation on most of their itemized deductions. Both curtailments are indexed, same as the tax brackets.

The 2001 tax act abolished these stealth taxes, but not right away and maybe not at all. The repeal is phased in – IRS lingo for a law change that becomes effective gradually or only after several years elapse.

What the 2001 legislation did was start a gradual elimination of the automatic cutbacks in 2006 and finish the job in 2010, which is equivalent to further reducing the top rates by about one percentage point, and, as a sort of congressional afterthought, actually simplified the tax code, a decision that had the support of no less than those kinder and gentler folks at the IRS, whose National Taxpayer Advocate said that “the confusing and complex calculations for determining allowable deductions add a significant tax and economic burden to a growing number of taxpayers.”

Stealth Taxes Resurrected?

In the meantime, stealth taxes remain on the books, at least through 2009. And who’s to say that ballooning budget deficits won’t provide Congress with a reason to renege on the cancellation before 2010? After 2010, the cancellation expires or “sunsets,” meaning stealth taxes are resurrected to what they were before passage of the 2001 act, unless Congress acts to abolish them again.

For 2003, exemptions begin the phasing out process when AGI surpasses $139,500 for singles, $209,250 for joint filers, $174,400 for heads of household and $104,625 for marrieds filing separately. They vanish when AGI is greater than $262,000, $331,750, $296,900 and $165,875 for singles, joint filers, heads of household and marrieds filing separately, respectively.

The disallowance of most itemized deductions is three percent of the amount by which 2003’s AGI tops $139,500 ($69,750 for marrieds filing separately -- going that route does not raise a couple’s threshold to a combined $279,000). Stated another way, every $1,000 of AGI above $139,500 results in the loss of $30 of itemized deductions.

3 % Restrictions on Deductions

The three-percent restriction applies to several categories of deductions, including:

  • State and local taxes, which is particularly irksome for filers in high-income-tax states like California, with its top rate of 9.30 percent, and New York, with its top State rate of 6.85 percent – boosted for those residing in New York City by its top rate of 4.45 percent
  • Interest on home mortgages
  • Real estate taxes
  • Charitable contributions
  • Miscellaneous expenses, already allowable, in most cases, just for the amount above two percent of AG

There are reprieves for four kinds of write-offs. But the exceptions are for deductions already subject to limitations. The three-percent rule does not apply to the following write-offs:

  • Medical expenses (deductible only for the amount above 7.5 percent of AGI)
  • Casualty and theft losses (allowable only to the extent such uninsured losses exceed $100 for each casualty or theft, plus 10 percent of AGI)
  • Gambling losses (allowable just to the extent of gambling winnings)
  • Interest on funds borrowed to finance investments, such as margin accounts used to buy stocks (allowable just to the extent of investment income, a category that includes dividends, interest and, subject to restrictions, capital gains)
A Real-World Example

To observe these stealth taxes at work, consider the following example of a hypothetical couple. For 2003, Adam and Alice Applegate anticipate an AGI $199,500. Their otherwise allowable itemized deductions for donations, home-mortgage interest, real estate taxes, state income taxes and other items aggregate $20,000. The couple’s income exceeds the $139,500 threshold by $60,000, and, as $60,000 times three percent equals $1,800, the couple are able to deduct just $18,200; they forfeit $1,800.

It takes just three simple math computations for the Applegates to figure out how much the disallowance increases their marginal tax bracket of 28 percent.

First: multiply their top bracket of 28 percent by the disallowed deductions of $1,800, for a result of $504. Next, divide the $504 by $60,000, the amount by which their AGI exceeds the threshold, for a result of 0.84. Finally, add 0.84 to their original bracket of 28 percent, resulting in a “real” tax bracket of 28.84 percent.

Adam and Alice suffer the same $1,800 disallowance, whether their itemized deductions are $20,000 or $100,000. That is because the disallowance is based on the amount by which AGI surpasses $139,500, not the total of itemized deductions. If it is any consolation, the curtailment cannot cancel more than 80 percent of their deductibles. They still are allowed to deduct 20 percent.

Suppose the Applegates’ itemized deductions are $30,000 and their AGI is $1 million. Sure, most millionaires have many more itemized deductions. Still, pairing $30,000 and $1 million is possible if their state is without an income tax, they rent their dwelling, and they make few charitable contributions. The most that their deductions can be trimmed by is $24,000 ($30,000 times 80 percent), leaving them with a deduction of $6,000.

Julian Block is a syndicated columnist, attorney and former IRS investigator who has been cited by the New York Times as “a leading tax professional” and by the Wall Street Journal as an “accomplished writer on taxes.” His “Year Round Tax Savings” covers key changes introduced by the 2003 tax act, shows how to save truly big money on taxes – legally – and explains the steps you should take to reduce taxes for this year and even gain a head start for future years.

Send $9.95 for an e-mailed copy or $14.95 (in the U.S.) for a postpaid copy to: J. Block, 3 Washington Square, #1-G, Larchmont, NY 10538-2032. He can be contacted at


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