The infamous duo of PEP and Pease are rules that reduce deductions that would otherwise be allowed to relatively high-income taxpayers. This page explains PEP: the personal exemption phaseout.
PEP was eliminated as part of the tax cuts enacted under George W. Bush but sprang back to life when those tax cuts expired at the end of 2012. The American Taxpayer Relief Act of 2012 raised the income levels at which PEP starts to apply.
These amounts will be adjusted for inflation after 2013. Note that these are dollar amounts of adjusted gross income (“AGI”), not taxable income. Capital gains are included in AGI, so a capital gain could trigger a reduction in your personal exemptions.
This rule works in a peculiar way. It reduces the amount of your personal exemption deduction by 2 percentage points for each $2,500, or fraction thereof, by which your AGI exceeds the threshold amount for your filing status. For example, a single filer would see no reduction in personal exemptions with AGI up to $250,000. With AGI of $250,001, personal exemptions would be reduced by 2 percentage points. Additional income would not make any difference up to $252,500, but another 2 percentage points would disappear with the next $1 of income. Instead of being smoothly phased out, personal exemptions are eliminated in a series of 50 discrete steps.
As you might guess, the increments for taxpayers who are married filing separately are $1,250 instead of $2,500.
If your income falls within the phase-out range, things are more complicated. The personal exemption amount for 2013 is $3,900, so each increment wipes out $78 of your deduction, increasing your taxable income by that amount. If you claim two personal exemptions, each increment wipes out twice that amount, or $156. A family of seven — say, mom, dad and five dependent children — would see $546 in deductions disappear with each increment.
With a single exemption, the amount of deduction you lose for each $2,500 increment is roughly 3% of $2,500. Income within the phaseout range is mostly taxed in the 35% tax bracket, so roughly speaking PEP increases the marginal tax rate in this range by about 1 percentage point (35% times 3%) for each personal exemption (but double that if you’re married filing separately).
But this is the average based on an increment of $2,500. Adding $100 to your income has no effect on your personal exemptions if your AGI falls just above one of the $2,500 increments. With AGI just below one of those increments, however, adding $100 of income will eliminate 2% of your personal exemptions — and with a large enough number of personal exemptions, this $100 of income could cost more than $100 in additional tax.