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How to Save on Taxes By Reducing Your Income Without A Pay Cut
Did you know that you can cut your tax bill by reporting a lower income without actually lowering your income or committing tax evasion? The trick is reducing your Adjusted Gross Income (AGI).
What is AGI?
Your Adjusted Gross Income is your income minus certain special deductions that directly reduce your income rather than reducing your taxes owed. These are commonly referred to as "above-the-line deductions" and include the following.
- Health savings account contributions
- Moving expenses
- Contributions to Traditional IRAs, 401(k)s, and other qualified retirement plans
- Student loan interest
- Alimony paid
- Other items listed in the Adjusted Gross Income section of Form 1040
Why is AGI Important?
AGI is the starting point for calculating taxes and provides three key benefits.
- Reduces your income tax owed by reducing your taxable income.
- Qualifies you for certain tax benefits based on AGI (see below).
- Entitles you to larger deductions or credits that are calculated based on a percentage of your income. For example, the Obamacare subsidy keeps you from paying no more than about ten percent of your AGI for health insurance. The lower your AGI, the higher your credit or deduction.
What Tax Benefits Are Based on AGI?
These are some of the common credits and deductions with AGI cutoffs.
- The traditional IRA deduction has several cutoff points depending on if you're married and if you have a retirement plan at work. The lowest cutoff is $61,000 for single filers with a work retirement plan.
- The student loan interest deduction is lowered if your AGI exceeds $65,000 and is eliminated if your AGI exceeds $80,000 (both numbers double if you're married filing jointly).
- The Affordable Care Act's subsidies are available to those whose AGI is less than 400 percent of the federal poverty level based on their family size ($80,640 for a family of three).
How Can You Lower Your AGI?
You can lower your AGI by using above-the-line deductions. For example, if your income for the year was $50,000 and you contribute the $5,500 maximum to a Traditional IRA, your AGI is $44,500.
One thing to note is the concept of Modified Adjusted Gross Income. MAGI essentially prevents double dipping. For example, you can't use your IRA contributions to reduce your AGI for the IRA deduction. Continuing the above example, you would take your $44,500 AGI and add back in your $5,500 IRA contributions for a $50,000 MAGI when you calculate your IRA deduction. However, your AGI for calculating your income taxes and other credits or deductions would still be $44,500.
To find out which above-the-line deductions you qualify for and if you've been paying the IRS too much, call a local tax professional today.