We have recently been getting questions and concerns about retirement and retirement plans from our clients. Many of these have to do with taxes and the changing rules for distributions, and show various levels of misunderstanding.

“I would donate to charity, but I make too much and they will cut my deduction.”

This statement refers to the Pease limitation, named for deceased legislator Donald Pease, who originally pushed through the concept a couple of decades ago. The reincarnation of the limitation was part of the fiscal cliff tax package, the American Taxpayer Relief Act of 2012.

It is true that high income earners are subject to a reduction of certain itemized deductions. High income in this context is adjusted gross income (AGI) in 2015 of over $258,250 (for single filers), $309,900 (for married, joint-filing couples), $284,050 (for heads of households), and $156,000 (for those who are married but filing separately).

Indeed, in certain circumstances, a charitable donation will not result in the expected tax deduction, but in many cases, the limitation has no effect on the tax break from a donation.

The disconnect in taxpayer understanding stems from the fact that the act of making the donation is not the trigger. AGI is the trigger. The reduction is 3% of the amount of AGI greater than the thresholds listed above. A single taxpayer with an AGI of $358,250 is $100,000 above the threshold, so $3,000 of certain deductions is disallowed.

Charitable deductions are among those targeted, as are deductions for home mortgage interest, property taxes and state and local taxes. Some other deductions found on Schedule A are exempted, including medical expenses and gambling losses.

Say our single making $358,250 pays state taxes, property taxes and mortgage interest totaling $40,000 and is getting that as a deduction. She is considering a charitable gift of $10,000 as well. With the Pease limitation, she deducts $47,000 if she makes the donation ($40,000 plus $10,000 minus $3,000). If the Pease limitation did not exist, she would deduct $50,000. It sure appears to be a reduction, but it actually isn’t.

The choice isn’t Pease or no Pease. It is donation or no donation. If the single filer donates $10,000, she deducts $47,000. If she does not donate, she deducts $37,000 ($40,000 minus $3,000). The $10,000 donation results in a full $10,000 additional deduction, so there is no reduction of her deduction.

The $3,000 figure does not rise if she increases her donation or other deductible expenses. It rises only when her AGI increases. The limitation is really better described as a surtax. For a peek at the calculations determining the size of the surtax, I recommend Michael Kitces’ 2013 write-up of the topic on his blog, Nerd’s Eye View.

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