What is the 3% reduction?
Note:For tax years after 2005, the 3% reduction no longer applies. The reduction is slowly being phased out. For the 2006 and 2007 tax year, you should instead check: What is the 2% reduction? The following is simply provided for an understanding of what the 3% reduction was for the 2005 tax year.
The 3% reduction is a limit placed on individuals who earn a relatively high level of income, which serves to slightly increase their tax burden. For the 2005 tax year, the 3% reduction applies to those taxpayers who have an adjusted gross income in excess of $145,950 (or $72,975 if they are married and filing separately). When a taxpayer has an adjusted gross income greater than this amount, the 3% reduction is generally applied to all of their deductions except for medical expenses, casualty and theft losses, gambling losses and investment interest expenses.
The 3% reduction works by decreasing the total amount of deductions one can take. In particular, if it applies to you, your overall deduction amount will be reduced by 3% of the difference between your adjusted gross income and the amount discussed above. For example, if your adjusted gross income for 2005 was $200,000, the difference between that amount and $145,950 is $54,050. Three percent of that is $1622, which means that your total deductions would be reduced by $1622.
To further complicate things, where your adjusted gross income is very high, there is an eventual limit to how much your deductions can be reduced by. Particularly, the 3% reduction can only reduce your deductions by 80%. So if your deductions were originally $15,000, the 3% reduction could only reduce them by $12,000. But for your 3% reduction to even reach the amount of $12,000, your adjusted gross income would have to be $545,950!