Monday, January 29, 2007


Most taxpayers concentrate on ways to reduce their “taxable income”. However, it is your “Adjusted Gross Income”, or AGI, that is 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 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 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 – 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 as 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 had an AGI of $130,450 for 2006. They were in the 25% tax bracket. John and Jane had three dependent children, two under age 17 and one who was a college freshman. They paid $5,000 in college tuition and their miscellaneous deductions were more than of 2% of their AGI.

If J and J had given $1,000 more to charity before year-end they would have saved $250 in federal income tax. If, instead, they could reduce their AGI by $1,000 they would put an additional $913 in their pocket.

By reducing their AGI from $130,450 to $129,450 they would be able to deduct an additional $2,000 in tuition and fees as an “adjustment to income”, which would further reduce their AGI. This brings their total AGI reduction to $3,000. As a result they would be able to deduct an additional $60 in miscellaneous deductions on Schedule A. The taxable income on their 2005 Form 1040 would be reduced by $3,060, which would translate to $763 less income tax.

The Child Tax Credit is phased-out by $50 for each $1,000, of part thereof, that a couple’s AGI exceeds $110,000. By reducing their AGI by $3,000 John and Jane would increase the credit by $150. The total tax savings would be $913 - $763 in reduced tax liability plus $150 in increased Child Tax Credit.

Any questions?



Anonymous said...

Great Article. Incredible points for me, as a first year tax preparer, to consider when doing returns. Thanks!

Anonymous said...

Just came across your name and website while doing some fun research re taxes on the internet. I say fun because my family and friends think everything and anything about taxes is boring, while I like to figure out legal ways to pay less and take advantage of all the legal tax breaks made available to us by Congress.

One such break -- not listed in your means of lowering AGI is in estimating flexible spending money in advance and lowering AGI, along with the taxes on it, and in addition, for some it might mean keeping AGI under $100,000 and also keeping AGI under the limits for ability to contribute to a ROTH IRA, and even for some who live in high tax states where deductions bring them down to 15% bracket versus a 25% bracket, it might make a big difference.

This does take work though and is not easy because of the "use it or lose it rule." When the IRS issued a ruling allowing using leftover contributions to Flexible Spending Accounts by March 15th of the following year, it was a big help, as no doubt, one cannot estimate actual medical, dental, eyeglass and over the counter permitted meds exactly. So one could wind up using leftover money from one year in January, February and half of March of the following year.

For example, $2,000 put aside in Flexible Spending saves Federal and state income and possible NYC or other city income tax and I believe would lower AGI accordingly. If by December 31, you had leftover $500, just make sure to have your dental and other legitimate medical deductible expenses met before March 15th (of the following year) and of course filed on a timely basis to use up the balance. That way you don't lose the advantage of setting aside the funds in Flexible Spending to begin with. You have also lowered your AGI for the year by the $2,000 and you also did not have to itemize your medical deductions where you may or may not have received any tax breaks for so doing. The $2,000 is only used as an example. You could contribute less or more subject to the maximum established by the law.

Greg said...

Are chartable donations an "above the line" deduction?

Robert D Flach said...



Contributions to church and charity are an Itemized Deduction. This is a "below the line" deduction - the line being AGI. Charitable deductions do not reduce AGI.


Anonymous said...

First of all, thanks for the article.

I have just one question, regarding the bullet: "Invest in tax-free municipal bonds or tax-deferred US Savings Bonds instead of bank CDs."

I am a government employee and we have a program to allow us to buy US Savings Bonds. On the 1040, above the line, I see no line item reduction for purchased US Savings Bonds. How then do they reduce AGI? I see the line items for moving expenses, IRA, tuition, etc., but nada for the savings bonds.

Could you plese explain where this is recorded.

Thanks! Again, great article.

Robert D Flach said...


You do not get a tax deduction for the purchase price of a US Savings Bond, like you may get for a contribution to an IRA.

It is not the actual amount of investment in a US Savings Bond that reduces your AGI. You reduce your AGI because the interest that is earned on US Savings Bonds is "tax deferred".

You do not pay tax on the current annual accrual of interest on a US Savings Bond each year (although you can elect to do so if you wish). The interest is not taxed until you cash in the bond - perhaps 30 years down the road.

The interest may also be exempt from tax if the bond is used to fund the higher education of a dependent.

The current interest on savings and money market accounts and, for the most part, CDs is taxed each year.