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 altogether eliminated, based on your AGI, or in some cases a “Modified” AGI (no gift from this MAGI), and several items of income are increased and some deductible losses are reduced 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 in excess of $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 Acts passed under George W all continued the trend of limiting credits and deductions based on AGI.
Items that are affected by your AGI (or MAGI) include:
* the taxable portion of interest on US Savings Bonds used to pay for education,
* losses from rental real estate activities with active participation,
* the taxable portion of Social Security and Railroad Retirement benefits,
* deductible traditional and spousal IRA contributions,
* the ability to contribute to a ROTH IRA, and to 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,
* job expenses and most other “miscellaneous” deductions,
* total Itemized Deductions,
* the deduction for personal exemptions,
* the dreaded Alternative Minimum Tax (AMT),
* the Credit for Child and Dependent Care Expenses,
* the Credit for the Elderly or Disabled,
* the HOPE and Lifetime Learning education credits,
* the Retirement Savings Contributions Credit,
* the Child Tax Credit,
* the Adoption Credit,
* the Earned Income Credit,
* Coverdell Education Savings Account contributions, 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 the education credits and the deductions for student loan interest and tuition and fees, the amount for joint filers is twice that for unmarried 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 Joint or Qualifying Widow(er). In some cases married taxpayers filing separately 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 gain distributions and long-term capital gains are taxed separately at a lower rate, both for the regular tax and the AMT, these items of income 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 of, or increase, the AMT.
Because of the way the taxable portion of Social Security and Railroad Retirement benefits is calculated, for every additional $1.00 of AGI you could be taxed on as much as $1.85. For a taxpayer in the 15% federal tax bracket who finds himself 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 make to reduce your AGI:
* Maximize “pre-tax” contributions to your 401(k), 403(b) or other pension or deferred compensation plans, including any “catch-up” contributions for participants age 50 or older.
* Maximize the amount of wages set aside in an employer-sponsored “pre-tax” medical expense or dependent care flexible spending account.
* Postpone the receipt of a year-end bonus until next year.
* Postpone billing clients until January, accelerate or prepay business expenses at 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 property.
* Sell investments at a loss to take advantage of the maximum $3,000 net capital loss deduction.
* Maximize deductible contributions to a traditional IRA, including catch-up contributions.
* Instead of deducting the total fee for tax preparation as a “miscellaneous” deduction on Schedule A, allocate a portion 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 that tax-exempt interest is included in the calculation of taxable Social Security and Railroad Retirement benefits).
Let us look at an example where reducing AGI by $1,000 could result in $913 less federal tax – a 91.3% tax savings!
John and Jane Q. Taxpayer anticipate an AGI of $130,450 for 2005. They will be in the 25% tax bracket. John and Jane have three dependent children, two under age 17 and one who is a college freshman. They paid $5,000 in college tuition and their miscellaneous deductions are more than 2% of their AGI.
If J and J gave an additional $1,000 to charity before year-end they will save $250 in federal income tax. If, instead, they can reduce their AGI by $1,000 they will put an additional $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 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 tax.
The Child Tax Credit is phased-out by $50 for each $1,000, or part thereof, that a married couple’s AGI exceeds $110,000. By reducing their AGI by $3,000 John and Jane will increase their Child Tax Credit by $150. The total tax savings is $913 – $763 in reduced tax liability and $150 in increased Child Tax Credit.