Adjusted Gross Income (AGI)
Gross Income (Salary, Investment Earnings, etc.)
– Allowable Deductions, Credits, and Exemptions
=Adjusted Gross Income
The goal is to reduce your AGI as much as possible by implementing tax strategy to legally downplay your income. Let’s break down the language and meaning behind this basic fundamental.
Credits vs. Deductions
First things first: How is a tax credit different from a tax deduction?
A tax credit reduces your tax dollar for dollar—that is, a $1,000 tax credit actually saves you $1,000 in taxes. By comparison, a tax deduction reduces your taxable income, but it is only worth the percentage equal to your marginal tax bracket.
For instance, if you are in the 25% marginal tax bracket, a $1,000 deduction saves you $250 in tax (.25 x $1,000), which is $750 less than the savings with a $1,000 tax credit. The higher your tax bracket, the more a deduction is worth, but a credit is always worth more than a dollar-equivalent deduction.
Tax credits reduce your tax bill, but certain restrictions, such as income limits, may apply. The American Taxpayer Relief Act of 2012 (ATRA) enacted in January 2013 makes permanent or extends some credits for child-related tax relief. If you have dependent children, you may be eligible to claim the adoption credit and the dependent care tax credit. If you are funding a child’s education, you may be eligible for the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit. The AOTC provides a tax credit of 100% of the first $2,000 of qualified tuition and related expenses, and 25% of the next $2,500 per eligible student applicable to the first four years of post-secondary education. The Lifetime Learning Credit is 20% on the first $10,000, subject to income phaseout.
All taxpayers may either claim a standard deduction or itemize deductions for personal expenses such as home mortgage interest. Income limits apply to taxpayers who itemize deductions. In general, a taxpayer claims an itemized deduction when the total of qualified deductible expenses exceeds the standard deduction or if the taxpayer does not qualify for the standard deduction. For tax year 2017, the standard deduction is $6,350 for single filers; $9,350 for heads of household; and $12,700 for married joint filers. For 2018 returns deductions with double, causing many people to abandon the hassle of itemizing. Read more about recent tax code changes here.
How is a deduction different from an exemption? Personal and dependent exemptions are reductions in gross income in addition to the standard deduction or itemized deductions. Every taxpayer may claim a personal exemption for him or herself, unless he or she is claimed as a dependent on another taxpayer’s return. For 2017 the exemption is $4,050. A married couple filing a joint return can claim two personal exemptions, one for each spouse. Even if one spouse has no income, that spouse is not considered the “dependent” of the other spouse for tax purposes. However, the exemption is subject to a phase-out that begins with adjusted gross incomes of $261,500 ($313,800 for married couples filing jointly). It phases out completely at $384,000 ($436,300 for married couples filing jointly). For 2018 returns exemptions are going away! Read more about recent tax code changes here.
Retaining as much of your gross income as possible should be an ongoing objective, not something that happens only at tax time. Above-the-line deductions, if you qualify, reduce your adjusted gross income. They are so named because they are taken on your tax form just above the line where you enter your AGI. Possible deductions include contributions to qualified retirement accounts, student loan interest, alimony, early withdrawal penalties, and certain moving expenses.
Long-Term Capital Gains and Dividends
As an investor, planning your tax strategy can have a significant impact on your tax liabilities, particularly since the passing into law of ATRA. For investors in the top income tax bracket, the long-term capital gains rate is 20% in 2017. That top rate applies to the extent that a taxpayer’s income exceeds the thresholds set for the 39.6% rate. All other taxpayers will have a capital gains and dividends tax at a maximum rate of 15%; however a 0% will apply to the extent income drops below the top of the 15% income tax bracket.
To prepare an effective tax strategy, advance planning is key. The sooner you begin, the greater your savings opportunities will be. Be sure to consult your tax professional to create strategies that are right for your unique circumstances.