When it comes to your finances, understanding the various components that make up your taxable income is crucial. Adjusted gross income (AGI) is a key element of that equation. It’s essentially your total income from all sources after you’ve made certain deductions and adjustments. However, there are a number of ways to reduce your AGI and lower your tax liability in a given year. Consider speaking with a financial advisor or tax expert if you need help managing your taxes.
What Is Adjusted Gross Income (AGI)?
In layman’s terms, AGI is a measure of your total income in a given year derived from various sources, such as wages, self-employment earnings, rental income and dividends, minus certain allowable deductions known as “above-the-line” deductions.
These deductions include specific expenses such as student loan interest, traditional Individual Retirement Account (IRA) contributions and certain business expenses, among others. Subtracting these from your total income gives your AGI.
To determine your taxable income, you then subtract the standard deduction or the sum of your itemized deductions from your AGI. In 2023, the standard deduction is $13,850 for individuals and $27,700 for married couples filing jointly. If your “below-the-line” deductions exceed the standard deduction (which changes each year), you’ll likely itemize instead of taking the standard deduction.
Ways to Reduce Your AGI
Now that we’ve covered the basics of AGI, let’s explore some strategies to help you reduce it, potentially lowering your overall tax liability.
Contribute to a Retirement Account
Contributing to a pre-tax retirement account, such as a 401(k) or a traditional IRA, is one of the most effective ways to reduce your AGI. While 401(k) contributions are not considered above-the-line deductions, the money you contribute to these accounts ultimately lowers your taxable income, reducing the amount of income subject to taxation.
For 2023, the annual contribution limit for a 401(k) is $22,500, and $6,500 for a traditional IRA. If you’re 50 or older, you can save an extra $7,500 in a 401(k) and $1,000 in an IRA. However, starting in 2024, taxpayers who earn $145,000 or more won’t be able to deduct their catch-up contributions.
Deduct Student Loan Interest
If you’re repaying student loans, you can potentially deduct the interest you paid on them. This deduction can lower your AGI by up to $2,500, depending on your income. To qualify, you must meet certain income requirements, and the loans must be used for qualified education expenses. This deduction can be particularly beneficial for recent graduates or those still in the early stages of loan repayment.
Deduct Education Expenses
If you’re a teacher, you may be eligible to deduct up to $300 of out-of-pocket classroom expenses in 2023. This can help cover the cost of books, supplies and other items that a teacher may purchase for their classroom. According to the IRS, “anyone who is a kindergarten through grade 12 teacher, instructor, counselor, principal or aide who worked in a school for at least 900 hours during the school year” is eligible.
Contribute to a Health Savings Account
Health savings accounts (HSAs) offer another opportunity to reduce your AGI. HSAs are designed for individuals with high-deductible health insurance plans. Contributions to an HSA are tax-deductible, and the money in the account can be used tax-free for qualified medical expenses. In 2023, the annual contribution limit for an HSA is $3,850 for individuals and $7,750 for families. Plus, if you’re 55 or older, you can make an additional $1,000 catch-up contribution. Keep in mind that you can deduct your contribution and whatever contribution your employer makes.
Deduct Business Expenses
If you’re self-employed or a small business owner, deducting business expenses is a crucial strategy to lower your AGI. Common deductible business expenses include office rent, utilities, office supplies, and more. By keeping accurate records of these expenses, you can reduce your AGI.
Other Ways to Reduce AGI
If you’re paying alimony or spousal support, you may be eligible for a tax deduction. However, there are specific IRS rules to follow. The payments must be made under a divorce or separation agreement that was executed before 2018. They also must be made in cash, check or money order.
Penalties for withdrawing money early from a savings vehicle like a certificate of deposit (CD) may also be deducted, reducing your AGI.
AGI vs. MAGI: How Are They Different?
AGI isn’t the only important tax-related acronym to familiarize yourself with.
Modified adjusted gross income (MAGI), on the other hand, is a bit more complex. It takes your AGI and makes further adjustments by adding back certain deductions that were subtracted from your AGI, such as student loan interest, IRA contributions and foreign earned income. Additionally, MAGI might include some income sources that aren’t part of your AGI, like tax-exempt interest from municipal bonds.
MAGI is used as a key parameter in determining eligibility for various federal programs and tax benefits. For instance, your MAGI affects your ability to deduct contributions to a traditional IRA on your tax return and your eligibility to contribute to a Roth IRA. Meanwhile, your MAGI is used to determine whether you qualify for premium tax credits to help you pay for health insurance under the Affordable Care Act.
Bottom Line
Understanding your adjusted gross income (AGI) and taking steps to reduce it can have a significant impact on your overall tax situation. By utilizing above-the-line deductions and making strategic financial decisions, you can lower your AGI and potentially reduce your tax liability. Remember that tax laws are subject to change, so it’s advisable to consult with a tax professional or financial advisor to ensure you’re maximizing your AGI-reduction strategies within the current tax code.
Tips for Managing Your Tax Liability
- Using investment losses to offset capital gains can help you lower your tax bill. This strategy, known as tax-loss harvesting, also allows you to use leftover losses to offset up to $3,000 worth of non-capital gains income.
- Consider working with a financial advisor with tax expertise. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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