Beware of Tax Planning “Cliffs”

A tax cliff occurs when one additional dollar of income beyond a certain threshold causes a sudden increase in your tax bill (or, in some cases, health insurance costs).

Most tax provisions don’t include tax cliffs. Instead, the effect of additional income is “phased in” over time. For example, with the American Opportunity Credit (for higher education expenses), you can claim the full credit if your income falls below a given threshold ($80,000 if single, $160,000 if married filing jointly). Then, as your income passes that threshold, the amount of credit you can claim is gradually reduced (“phased out”) until it reaches zero.

But with provisions that include tax cliffs, the change happens all at once. You either get the full deduction/credit or no deduction/credit. There’s no room in between. In such situations, that one dollar of income that puts you beyond the threshold can cost you hundreds or even thousands of dollars.

For example, all of the following provisions include cliffs:

• Retirement savings contribution credit
• Tuition and fees deduction
• Affordable Care Act cost-sharing reductions
• Premium tax credit (The PTC phases out gradually as income increases, but then it suddenly drops to zero when household income exceeds 400% of federal poverty level.)
• Medicare Income-Related Monthly Adjustment Amount (IRMAA)
• Earned Income Tax Credit (The EITC normally phases out based on adjusted gross income, but an otherwise-eligible taxpayer becomes completely ineligible, all at once, as soon as their investment income exceeds a certain threshold — $3,650 for 2020.)

There are many at the state level as well.

Avoiding Tax Cliffs

When possible, the goal is to avoid a situation where you end up just barely on the wrong side of a given cliff threshold.

The area in which people are most likely to have flexibility (i.e., ability to adjust income on demand, in order to avoid a cliff) is with regard to retirement accounts (i.e., by adjusting the balance of Roth/tax-deferred contributions if still working or distributions if no longer working).

A tricky point, however, is that the income being measured varies from one provision to another.

• The retirement savings contribution credit is concerned with your adjusted gross income;
• The tuition and fees deduction is concerned with modified adjusted gross income;
• ACA premium tax credit and cost-sharing reductions are concerned with household income;
• IRMAA is concerned with modified adjusted gross income (but the “modifications” to adjusted gross income are different than they are for the tuition and fees deduction); and
• The EITC cliff is concerned with investment income.

Using tax prep software can be a helpful way to test for such cliffs. For instance, it can be helpful to prepare a hypothetical return in advance (e.g., using the 2019 version of the software to prepare a hypothetical return now, for 2020). See what your projected tax bill would be, then see how it would change if, for instance, you made an additional $1,000, $2,000, $3,000 etc. of tax-deferred contributions. At some point you might find that there’s a sharp decrease in the projected tax bill.

To be clear though, that method is not perfect, for a few reasons. Firstly, it won’t catch cliffs that affect something other than your taxes (e.g., IRMAA or Affordable Care Act cost-sharing reductions). In addition, it’s imprecise given the fact that you’d be using 2019 software for a 2020 return, and the relevant thresholds can change from one year to the next. And in situations in which major tax legislation has been passed, the exercise could be entirely off the mark.

Still, it’s often useful as an easy way to do a quick check.

More broadly though, it’s helpful to develop an awareness of which provisions involve cliffs, and then to be mindful of the one(s) that are most likely to affect you, so that you can look up the relevant threshold(s) when necessary. (For instance, if you buy health insurance on the exchange, you generally want to have Affordable Care Act subsidies in mind when making any tax-related decisions.)