How to Reduce Your Taxable Income / AGI
- September 22, 2021
- by Michael
Paying taxes sucks. What you might not know is that you can lower your taxable income so you end up paying much less in taxes. Even if it is late in the year, there are still a few ways to lower your tax bill.
Your gross income, taxable income, Adjusted Gross Income (AGI), and Modified Adjusted Gross Income (MAGI) are the four main numbers used to determine your total tax bill. It is relevant to know these amounts because there are a number of tax triggers or benefit phase outs that happen as income increases. See the complete list of tax triggers based on income here.
In this post you will find different ways to reduce AGI / MAGI / taxable income so that your tax due also decreases.
What Is Gross Income?
Gross income is everything you earned before factoring in expenses or deductions. For wage earners this is the big number on your W-2. For self employed people this is how much money you collected through your business before any expenses are subtracted. For retirees this is money withdrawn from 401k or traditional IRA accounts, and possibly social security and pension income.
Earning less is one way to reduce your tax burden, but what we really want to do is keep a high gross income, while showing a low taxable income.
What Is AGI?
AGI or Adjusted Gross Income is calculated by taking your gross income and subtracting certain things such as IRA / 401k retirement contributions, alimony payments, interest on student loans, business expenses, etc.
What Is MAGI?
MAGI or Modified Adjusted Gross Income is a bit arcane and takes a bit of explanation. First it is calculated differently depending on what tax program or law is being looked at. You will not see the MAGI on your tax return but it will be buried in the worksheets / hidden sections if you use a tax filing software program. Typically MAGI is AGI plus half of self employment tax, nontaxable social security benefits, tax-exempt interest, untaxed foreign income, etc.
For people with simple tax returns MAGI may be the same as AGI. We wrote up a complete guide for calculating MAGI across over 12 categories.
What Is Taxable Income?
Taxable income is the portion of your AGI that you pay taxes on to the government after final adjustments take effect. The typical adjustment is the “standard deduction” which is based on filing status and the number of dependents you have. Some people are better off itemizing their deductions in the case where they have enough special deductions that add up to more than the standard deduction.
Taxable income is calculated by deducting your allowable standard deductions from adjusted gross income (AGI). Your taxable income will be less than your AGI due to the deductions.
How Do You Reduce Your Taxable Income / AGI / MAGI?
Any reduction in your gross income -> AGI -> MAGI -> taxable income will lead to a reduction in your taxes. Here are some strategies for getting your tax bill lower:
Contribute to IRA / 401k plan:
Contributing to a retirement plan is the easiest and most effective way of reducing your tax bill. The money that you contribute to the plan becomes a pre-tax contribution. For example, let’s say you earn $100,00 per year. If you contribute $15,000 to your 401(k) your AGI would drop to $85k. If your overall tax rate (fed + state) is 20%, that would be like getting $3,000 of the $15,000 contribution paid for by the IRS. The government is effectively subsidizing retirement savings for people that take advantage of this rule.
One thing to remember is that traditional IRAs and 401(k) are not tax-exempt. They are tax-deferred, which means you will pay taxes when you withdraw the money in retirement. The opposite of this is to use a Roth IRA / 401(k) which is an after-tax contribution, but offers tax-free withdrawal at retirement.
If you don’t have a retirement plan at work - consider a Traditional IRA which you can contribute up to $6,000 (for 2021).
For Business Owners:
Business owners are taxed on their profits (gross receipts, minus expenses, minus depreciation). This provides a lot of flexibility. Many businesses claim zero profit, which is how so many big corporations avoid paying taxes.
One way small business owners can lower their tax burden is to purchase more equipment in the current year. For example you might want to buy that new laptop or replace all your worn out office furniture sooner than later.
Another strategy is to delay invoicing a bit at the end of the year to push the accounts receivable into the next year.
Business Owners also have access to some incredible retirement options including the Solo 401(k) which allows both employer and employee contributions, meaning you can more than double the standard 401(k) contribution limit.
Consider a self-employed person who makes a profit of $100,000. With a Solo 401(k) they can contribute $19,500 on the employee side (just like a work sponsored 401k), and 18.5% of their profit ($18,500) on the employer side. That takes their taxable income down to just $62,000!
Donate to Charity:
Donating to charity is another way to reduce your taxable income. If you are making cash donations, then ensure that you have proof of the donations. You can either keep a canceled check or get your credit card statement.
For large contributions, you need to have the charity’s acknowledgment.
You can also give charity in kind by buying books, clothes, food, and other required items. For this, you will need to keep the bill or invoice for the purchases you have made for the charity.
Even travel related to charity can be deductible with proper proof.
Flexible Spending Accounts:
If you want to reduce your tax bill, flexible spending accounts are another option. These are typically provided through your employer. They allow you to pay for medical expenses (doctors visit, prescriptions, etc) or dependent care expenses (day care, nanny, elder care) using pre tax money.
When you sign up, each pay period a predetermined amount, say $100, is taken out of your paycheck and put in a special account. That money is not taxed. If you were in a 25% tax bracket, you could choose between having $75 to spend on anything you want, or having $100 for medical expenses. This makes sense if you know your medical or dependent care expenses will be steady.
You need to, however, follow the rules of pre-taxed funds properly. If the fund is not used following the rules, you could lose the pre-tax fund benefits. From personal experience the paperwork for filing reimbursements can be a bit of a headache. Another thing to be aware of is contributions to flexible spending accounts reduce your social security credits (unlike retirement contributions) so they can eat into your social security benefits.
Sell All Your Losses:
Before the end of the year, if you have any investments in the red you can sell these at a loss to offset other capital gains, and beyond that up to $3,000 of taxable income. This strategy is called tax loss harvesting. Some robo advisors do this for you automatically to try and lower your tax bill. You need to be careful of “wash sales” where you sell and then purchase an equivalent investment within 30 days.
Deduct High Medical Expenses:
In some instances, you can deduct your medical expenses. That happens only in two key cases.
- You itemize deductions (instead of taking the standard deduction).
- You pay more than 10% of AGI on your medical expenses.
If you pay any medical expenses from your income in these two conditions, it will be deductible. If you are eligible for the deduction, it is better to bundle all your medical payments into one year.
You can also pay your past or future expenses in the current year. However, this is only possible if the medical provider approves. Through this, you increase your current year’s medical expenses and reduce your taxes.
No matter which tax reduction solution you go for, it has to be legitimate. Tax auditors can easily catch fraudulent and illegal practices for reducing taxable income.
Reducing your taxable income, AGI or MAGI helps reduce your taxes. Being aware of the IRS income level triggers and managing your retirement contributions, charity contributions, business expenses, etc can help you to avoid losing out on a tax benefit you thought you would get. In some cases an unexpected bonus can bump you into another tax bracket and end up mostly going to the IRS.