“Watch Out for the Cliff!”

The IRS Code is extremely complex and laden with technical jargon. There are also some “tax traps” that might be avoidable if a taxpayer plans ahead. One of those traps deals with the method that the tax code uses to qualify taxpayers for certain benefits. For example, some tax breaks are “phased out” over a range of income giving the taxpayer a partial tax break. Roth IRA eligibility is a good example. For an otherwise qualified married taxpayer filing jointly (MFJ), 2021 Roth IRA contribution eligibility begins to phase out if the Adjusted Gross Income (AGI) exceeds $198,000. The phase out range is $198,000 to $208,000 so a couple reporting an AGI of $203,000 is right at the midpoint of the eligibility range. They are allowed to make 50% of the maximum contribution that a MFJ taxpayer making less than $198,000 could make. Only eligible MFJ taxpayers with AGI’s exceeding $208,000 are completely ineligible due to income. While this may seem like a complicated eligibility criteria, it is certainly less harsh than “cliff eligibility”.

The taxation of Social Security benefits is an example of a cliff. If a MFJ household has a provisional¹ income of $31,999 or less, none of their Social Security payments are taxed. However, simply increase that provisional income by $1 and now 50% of their Social Security payments become taxable. A similar “cliff” awaits them at a provisional income of $43,999 where one additional dollar of provisional income makes 85% of their Social Security subject to taxation. 

Therefore, taxpayers who are expecting to claim certain tax benefits should pay close attention to the methods used to determine eligibility. If the taxpayer has any control over the recognition of income (deferring a bonus, for instance), it can sometimes be wise to postpone receiving that additional dollar of income into the following tax year!

If you would like to learn more about these and other wise financial planning moves, please contact us through our Level 5 Financial LLC website or via phone at 719-323-1240.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.  You should consult your own tax, legal and accounting advisors before engaging in any transaction.

¹Provisional income equals 50% of the Social Security benefit, plus any tax-exempt interest as well as other non-Social Security income items that make up Adjusted Gross Income.