Most taxpayers focus on ways to reduce their “taxable income.” However, since the Tax Reform Act of 1986, your “Adjusted Gross Income,” or AGI, has become the most important number on your tax return.
Many tax credits and deductions are phased out, or eliminated entirely, based on your AGI or, in some cases, a “modified” AGI (no donation from this MAGI), and various items of income increase and some deductible losses are decrease as this number grows.
The Tax Reform Act of 1986 started the ball rolling by limiting the allowable rental loss deduction for taxpayers with an AGI greater than $ 100,000 and phasing out the amount of IRA contributions that could be deducted based on an AGI threshold. The Budget Reconciliation Act of 1990, the Taxpayer Relief Act of 1997, and the many tax laws passed under George W continued the trend of limiting AGI-based credits and deductions.
Items that are affected by your AGI (or MAGI) include:
* the taxable portion of interest on US savings bonds that is used to pay for education,
* losses from real estate rental activities with active participation,
* the taxable portion of Social Security and Railroad Retirement benefits,
* Deductible contributions from traditional and spousal IRAs,
* the ability to contribute to a ROTH IRA and convert a traditional IRA to a ROTH,
* student loan interest,
* the deduction for tuition and fees,
* medical and dental expenses,
* charitable contributions,
* casualty and theft losses,
* work expenses and most other “miscellaneous” deductions,
* Total itemized deductions,
* the deduction for personal exemptions,
* the dreaded Alternative Minimum Tax (AMT),
* Credit for Child and Dependent Care Expenses,
* Credit for the Elderly or Disabled,
* HOPE and Lifetime Learning educational credits,
* the Retirement Savings Contribution Credit,
* the Child Tax Credit,
* the Adoption Credit,
* the Earned Income Credit,
* Contributions to the Coverdell Education Savings Account, and
* the safe harbor amount for quarterly estimated tax payments.
Each of the items listed above has a separate set of AGI thresholds. For some items, such as education credits and deductions for student loan interest and tuition and fees, the amount for joint taxpayers is double that for single taxpayers; for some it is not. For the reduction of itemized deductions, the threshold is the same whether you file as single, head of household, married filing jointly, or qualified widower. In some cases, married taxpayers filing separate returns are not allowed the deduction or credit at all; in others, the threshold for separate filers is half that for joint filers.
While qualifying dividends, capital gains distributions, and long-term capital gains are taxed separately at a lower rate for both regular tax and AMT, these income items are included in your AGI. , as well as your Alternative Minimum Taxable Income (AMTI), and can reduce or eliminate the various deductions and credits affected by AGI, and cause you to become a victim or increase the AMT.
Due to the way the taxable portion of Social Security and Railroad Retirement benefits is calculated, for each additional $ 1.00 of AGI you may be subject to taxes of up to $ 1.85. For a taxpayer in the 15% federal tax bracket in this situation, a $ 1,000 increase in AGI could increase the tax liability by $ 278.00, almost 28%.
There are several moves you can do to lower your AGI:
* Maximize “pre-tax” contributions to your 401 (k), 403 (b) or other pension or deferred compensation plans, including “recovery” contributions for participants age 50 and older.
* Maximize the amount of wages set aside in an employer-sponsored “pre-tax” medical expense account or flexible dependent care spending account.
* Postpone receiving a year-end bonus until next year.
* Postpone billing clients until January, accelerate or prepay business expenses at the end of the year, and maximize contributions to a SEP, SIMPLE, or Keogh plan if you are self-employed.
* Expedite or prepay expenses at the end of the year if you own a rental property.
* Sell investments at a loss to take advantage of the $ 3,000 maximum net equity loss deduction.
* Maximize deductible contributions to a traditional IRA, including catch-up contributions.
* Instead of deducting the total tax preparation fee as a “miscellaneous” deduction on Schedule A, assign a portion of the fee, if applicable, to Schedule C and / or Schedule E.
* Invest in tax-deferred US tax-free municipal bonds or savings bonds instead of bank CDs (remember that tax-exempt interest is included in the calculation of taxable Social Security and Railroad Retirement benefits).
Let’s look at an example where reducing AGI by $ 1,000 could result in $ 913 less federal taxes – a 91.3% tax savings!
John and Jane Q. Taxpayer anticipates adjusted gross income of $ 130,450 for 2005. They will be in the 25% tax bracket. John and Jane have three dependent children, two under the age of 17 and one who is a freshman in college. They paid $ 5,000 in college tuition and their miscellaneous deductions are more than 2% of their AGI.
If J and J donated an additional $ 1,000 to charity before the end of the year, they will save $ 250 in federal income taxes. If instead they can lower your AGI by $ 1,000, they’ll put an additional $ 913 in your pocket.
By reducing their AGI from $ 130,450 to $ 129,450, they will be able to deduct an additional $ 2,000 in tuition and fees as an “adjustment to income,” which will further lower their AGI. This brings your total AGI reduction to $ 3,000. As a result, they will be able to deduct an additional $ 60 in miscellaneous deductions on Schedule A. The taxable income on their 2005 Form 1040 is reduced by a total of $ 3,060, which will translate to $ 763 less income taxes.
The Child Tax Credit is eliminated by $ 50 for every $ 1,000, or part thereof, that a married couple’s adjusted gross income exceeds $ 110,000. By reducing their adjusted gross income by $ 3,000, John and Jane will increase their Child Tax Credit by $ 150. The total tax savings are $ 913 – $ 763 in reduced tax liability and $ 150 in increased child tax credit.