Most taxpayers concentrate on ways to reduce their “taxable income”. However, beginning with 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 an “Modified” AGI (no gift from this MAGI), and more income items increase, and some deductible losses decrease as this number grows.
The Tax Reform Act of 1986 started the bullet by limiting the allowable tax loss deduction for taxpayers with an AGI of over $ 100,000 and phasing out the amount of IRA contributions that could be deducted based on an AGI threshold. The 1990 Budget Reconciliation Act, the 1997 Tax Relief Act, and the many tax laws passed under George W, all continued the trend of limiting credit and deductions based on AGI.
Items affected by your AGI (or MAGI) include:
* the taxable portion of interest on US savings bonds used to pay for education,
* loss of rental property with active participation
* the taxable portion of social security and rail services;
* deductible traditional and spouse IRA contributions,
* the ability to contribute to a ROTH IRA and convert a traditional IRA to a ROTH,
* student loan interest rates,
* deductions for tuition and fees
* medical and dental expenses
* charitable contributions,
* loss and theft,
* job expenses and most other “miscellaneous” deductions,
* total itemized deductions,
* deductions 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 education credits
* Pension contribution,
* the tax on children,
* Adoption credit,
* the credit earned,
* Contributions from the Coverdell Education Savings Account and
* The Safe Harbor amount for quarterly estimated tax payments.
Each of the above items has a separate set of AGI thresholds. For some items, such as education credits and student loan deductions and tuition and fees, the amount for joint filers is twice that of unmarried taxpayers; for some it is not. For the reduction of specified deductions, the threshold is the same whether you are filing as a single person, head of household, married filing partner or qualifying widow (s). In some cases, married taxpayers filing separately are not allowed deductions or credit at all; in others, the threshold for separate filers is half that of common filers.
While qualifying dividends, capital gains distributions and long-term capital gains are taxed separately at a lower rate, both for ordinary tax and AMT, these income items are included in your AGI as well as your Alternative Minimum Tax Income (AMTI), and can reduce or eliminate the various deductions and credit that are affected by AGI and cause you to become a victim of or increase AMT.
Because of the taxable portion of Social Security benefits and rail traffic, for each additional $ 1.00 AGI you can be taxed as much as $ 1.85. For a taxpayer in the 15% federal tax chamber in this situation, a $ 1,000 increase in AGI can increase the tax liability by $ 278.00 – nearly 28%.
There are several steps you can take to reduce your AGI:
* Maximize “pre-tax” contributions to your 401 (k), 403 (b) or other retirement or deferred compensation plans, including any “catch-up” contributions for participants 50 years or older.
* Maximize the salary amount set aside for an employer-sponsored “pre-tax” medical expense or dependent care account.
* Postpone receiving a bonus at the end of the year until next year.
* Postpone billing clients until January, accelerate or prepay business expenses by year-end and maximize contributions to a SEP, SIMPLE or Keogh plan if you are self-employed.
* Accelerate or prepay expenses at year end if you own rental housing.
* Sell investments at a loss to take advantage of the maximum $ 3,000 net capital deduction.
* Maximize deductible contributions to a traditional IRA, including fundraising.
* Instead of deducting the total tax preparation fee as a “second” deduction in Schedule A, allocate part of the fee, if applicable, to Schedule C and / or Schedule E.
* Invest in tax-free municipal bonds or tax-deferred US savings bonds instead of bank CDs (remember, tax-exempt interest is included in the calculation of taxable social security and railroad pension benefits).
Let’s look at an example where reducing the AGI by $ 1,000 can result in $ 913 less federal tax – a 91.3% tax saving!
John and Jane Q. The taxpayer expects an AGI of $ 130,450 for 2005. They will be in the tax range 25%. John and Jane have three dependent children, two under the age of 17 and one who is a college beginner. They paid $ 5,000 in college tuition, and their miscellaneous deductions are more than 2% of their AGI.
If J and J gave another $ 1,000 to charity before the end of the year, they would save $ 250 in federal income tax. If they can instead reduce their AGI by $ 1,000, they put another $ 913 in their 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 reduce their AGI. This brings their total AGI reduction to $ 3,000. As a result, they will be able to deduct an additional $ 60 in miscellaneous deductions in Schedule A. The taxable income on their 2005 Form 1040 will be reduced by a total of $ 3,060, which is $ 763 less income tax.
The child tax deduction is phased out by $ 50 for every $ 1,000 or part of a married couple’s AGI exceeding $ 110,000. By reducing their AGI by $ 3,000, John and Jane 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.