Hate is a strong word.
I didn’t let my children use the word as they grew up. But I hate taxes. OK, I don’t exactly hate taxes. I don’t like them much, but they have their place in society. So, let me clarify. What I hate is all the process of figuring out my stuff and getting the taxes prepared and filed. I hate it.
Nevertheless, here I am writing about income taxes. Is it even worse I’m writing about something sort of technical regarding taxes? Adjusted Gross Income. Wait! Don’t fall asleep! Keep reading! It isn’t as bad as you might imagine. In fact, if you understand Adjusted Gross Income (AGI) even a little bit more in the next couple minutes, it could be worth thousands of dollars to you. Every year! Seriously! Thousands! And I’m talking real money, not Schrute Bucks.
Your AGI is the key to money you get to keep and money you could be getting. I’ll make it simple as we talk about AGI and how it can put dollars in your pocket.
- First, your AGI is the deciding factor on whether you get a bunch of tax credits, including college-related credits, child credits and earned income credits.
- Second, your AGI determines whether you get phased out of the lower tax brackets and into higher tax rates and you lose your personal exemptions.
- Third, your AGI is the trigger for losing out on certain common deductions (like state taxes and charitable gifts).
- Fourth, AGI is the starting point for the income tax you owe to most states.
- Fifth, AGI controls your access to programs that involve federal government participation, including self-employed health insurance and college financial aid through the Free Application for Federal Student Aid (FAFSA), including Pell Grants and student loans.
The basics about AGI are easy to understand. Most of us want to earn as much money as we can. But when it comes to paying taxes, we try to legally make our taxable income as low as possible. How can we manage AGI in ways that put thousands of dollars in our pocket? We start by talking about the money we earn. That’s total income. Total income includes everything we earn. It includes the money we earn at our jobs. It includes the money we earn from any businesses we run. Gross income includes any interest we earn and anything we made on investments (but not increases in our 401(k) or IRA).
We start by adding up our income from all the sources. That’s total income. Remember this step for later in our discussion, because there are some great tricks we can, and should, use to legally come up with total income.
There are a few things we use to make total income smaller to arrive at AGI. Some of the most common things we get to deduct from income include interest on student loans, payments to an IRA, moving expenses and college tuition. We deduct these items from total income and the result is AGI.
Here’s a critical learning point. AGI is not the number we pay taxes on. We pay taxes based on something called taxable income. There’s another step between AGI and taxable income. After AGI is calculated, we get to subtract expenses called deductions. These are the expenses most people think about as “tax deductions.” In addition to these deductions, we also get to deduct a set amount for each person filing the tax return and for anyone we claim as our dependent on the tax return. Most often, our children are our dependents until they earn their own income and live on their own. Taxable income is AGI after we subtract common deductions and exemptions.
At this point in our discussion we need to figure out what the government will let us subtract from AGI as deductions. This is especially important because many people have something to learn about deductions and how they relate to AGI. Ask yourself, what kinds of expenses we can deduct from our taxes. Let’s make a partial list of some common answers.
- Taxes we pay (like to our state and local governments)
- Interest we pay on our mortgage
- Gifts we make to charities
- Medical and dental expenses
- Some expenses for our job
- Interest we pay relating to investments
Most people will think of at least some of these. These deductions are normally referred to as “Itemized Deductions” and they have their own tax form where they are listed (Schedule A, Form 1040). What happens if we don’t have these expenses? Or, what if we spent very little money toward these expenses? In those cases, instead of adding up all these itemized deductions, the government allows us to deduct a set amount from our AGI ($12,700 for a married couple in 2017). This set amount is called the “standard” deduction. We either get to deduct our itemized deductions or the standard deduction.
Generally, whether we claim the total of our itemized deductions or whether we choose to use the government’s preset standard deduction, depends on which amount greater. We usually want to use the larger amount, so we reduce our income the most possible before taxes are calculated. Whether we end up using the standard deduction or itemized deductions, in both cases, we start with AGI, we subtract standard or the itemized deductions and then we also subtract our exemptions. The ending number is taxable income.
Whew! Are you bored yet? Here comes the good part. I really will show you how this can mean thousands of dollars in your pocket. This is the part many people have never heard about. This is the part most people don’t understand.
Does it surprise you to know that none of the itemized deductions help to lower AGI? None! We could give half of all our income to charity and we could pay the other half for taxes and medical expenses and our AGI wouldn’t drop a penny. Those deductions might reduce our taxable income, but depending on our AGI, those deductions might be completely disallowed! In addition, when our AGI is high, not only do we lose the ability to use some of our itemized deductions, we also lose the benefit of the personal exemptions. Also, remember from the beginning of this article that AGI is important because it is the number that will decide whether we get tax credits and whether we lose out on lower tax rates. AGI is also the factor that mostly determines state income taxes and federal money for college and other programs.
When I learned that the most common deductions don’t reduce AGI, I had several questions. My first question was who came up with this crazy system? That’s a question for another day. For now, we will stick to two questions with easier answers. First, if those itemized deductions don’t reduce our AGI, then what good are they? And second, are there deductions that do change AGI? Let’s take the questions in order.
First, those deductions don’t reduce AGI, but they can still be useful because they usually lower our taxable income. The challenge is, as I also mentioned before, that if our AGI is too high, then we no longer get credit for some of our itemized deductions. In that case they don’t reduce AGI and they don’t reduce taxable income. If our income is too high such that we lose some or most of our itemized deductions, then instead, we end up having to settle for the smaller, standard deduction. When this happens, our taxable income ends up being higher than it would be with itemized deductions. But tax law says that a higher AGI means we lose many of our itemized deductions. This should reinforce the idea that it is better if we can reduce our income before we get to AGI.
On the basic federal tax form, the Form 1040 and 1040A, the bottom line of the form is AGI. The top line of the second page is this same amount, carried from the bottom of the first page. The bottom of the first page and top of the second page are the same amount – AGI. Deductions taken on the first page, before we calculate AGI, are often referred to as “above the line” deductions. Deductions allowed on the second page, itemized deductions or standard deductions, are referred to as “below the line” deductions.
The rest of this article is about how deductions taken above the line have an enormous impact on both the federal and state income taxes we pay, the tax credits we can take and the impact our AGI has on available financial help for college. Smart taxpayers know how to pack the most of their expenses and deductions above the line to reduce AGI as much as possible. Generally, if we have a choice between a deduction above the line and a deduction below the line, above the line is better, a lot better.
When we talk about deductions, we know a couple things. We know that a deduction can reduce the amount of tax we pay. I also like to point out that it usually makes no sense to spend money just to get a tax deduction. On the other hand, if we are going to spend money anyway and we can get a tax deduction in the process, that can be great. With these ideas in mind, I suggest that for money we are going to spend anyway, let’s find a way to spend it so that we can legally reduce our income and the taxes we owe.
How we earn our money makes a big difference in what we can deduct to get to AGI. Most people earn money at a job. Their employer gives them a W-2 form each year to report what they’ve earned to the government. As an employee, we can take deductions, below the line, for the itemized deduction items we have already talked about. We can also deduct a couple items (IRA contributions, moving expenses, student loan interest) above the line. And that’s it.
If our only income is from employment reported on a W-2 form, we are very limited in what we can deduct. We have little control over our AGI. In most cases, our income and our AGI end up being the same number. But, if we have a legitimate business in addition to our employment, suddenly we have ways to legally make a bigger part of our life qualify as a deduction, above the line, to reduce both our AGI and our taxable income! Suddenly some (even a lot) of the money we are spending anyway to live becomes eligible as an above the line deduction.
This is the part I referred to earlier when I said that there are some great tricks we can use to figure out our total income. Income from our personal business gets recorded above the line, but it shows up after all the expenses have already been deducted. That means that when we have a business, the limits of the itemized deductions and the small list of other above the line deductions are no longer the only way for us to deduct expenses. With our own business, the income gets reported after we deduct the expenses we chose to spend to run our business. We have control over how much income legally shows up in the total above the line!
Aren’t you glad you stayed with me to get this far? Without getting too technical, let’s just say that most of whatever we spend to run our own business can be a tax deduction if we follow the rules. The basic rules are simple. Of course, we need to run our business with the intent to make a profit. We must run our business in a way to clearly separate our personal life and our business activities. We keep records of what we do in our business. And when we have a business and when we follow the rules, we have much greater control over both AGI and taxable income.
Let’s review some of the biggest deductions and benefits we can receive from having a business of our own, even a part-time business. At another time we can discuss how to structure your business and whether you should run your company under your personal name or as a partnership, an LLC, a corporation or an “S” corporation. Each of these has advantages and disadvantages and there are tax differences to consider. We’ll look at the basic things these business structures have in common for above the line deductions and control of AGI and taxable income.
Perhaps the biggest benefit of running our own business is the ability to deduct the use of our car or truck. In 2017, the tax law states that we can deduct 53 ½ cents for every mile we drive for business. (Note that some technical folks will read this article and respond that in some small businesses can’t deduct the business use of our personal vehicle. What they mean to say is that some small businesses aren’t allowed to deduct the “actual” vehicle expenses and take depreciation expense on the vehicle. The business can’t deduct the cost of tires and tune ups and gas. But the business CAN deduct the amount they reimburse us for the 53 ½ cents per mile reimbursement. That discussion goes beyond our discussion today). The vehicle deduction is important because most of us drive our vehicles a lot and that represents a lot of potential tax savings and dollars in our pocket.
So, consider a couple ideas. When we have a business, if we drive to the post office to send business mail at the same time we are going to get groceries, then the mileage to and from the post office is suddenly and legitimately an above the line tax deduction in calculating our business income. If we pick up some office supplies while running other errands, our mileage becomes a deduction. If we drive somewhere and the activities involve talking about our business with potential customers or clients, our mileage can now be used to reduce our AGI and our taxable income.
If we drive our personal car 1,000 miles in a year for our business, we could reimburse ourselves $535 from our business (1,000 miles times 53 ½ cents per mile). It probably didn’t cost $535 in gas to drive 1,000 miles. The business gets a deduction for the $535 against income. And we personally don’t owe income tax on the $535 we put in our personal pocket. If we drove 10,000 miles, the use of our vehicle in a small business, even a part-time business, can be worth a thousand dollars or more in tax savings in a year. When we are trying to eliminate debt and build wealth, these dollars all make a big difference in both the short-run and the long-run.
To run a business, we probably need to use a cell phone. We probably need a computer. We probably need Internet access. By following the rules and using these things regularly in our business, they become at least partially tax deductible. If we don’t have a business, I bet we have these things, but they aren’t tax deductible at all, either above or below the line.
Here’s a tip that more business owners should use. When we own our own business, our business can legally rent our home for business purposes for up to fourteen days per year and the income is not taxable. If it is fourteen days or less, it is 100% tax-free. One idea is to rent our home to someone else to generate income. Think of this as a fourteen-day-per-year Airbnb. The idea I like even more is to rent our home to our own business for business meetings and activities. The money our business pays to rent the home is a deduction, above the line, to the business. And the business pays that money to us personally and we don’t have to pay tax on it. It is legally tax-free.
If you want the reference to help put you to sleep, look up Internal Revenue Code Section 280A(g) on this one. This valuable tax benefit is not limited to just one “home.” It can be used for every “home” we have personally. The tax law says that our home can include a boat, RV and vacation property. Just keep to the guidelines. This tool for managing AGI and taxable income is potentially worth thousands per year in tax-free income and reduced income taxes.
If a couple has a business together, the legal tax deductions expand. Meals and entertainment are legal deductions to a business. When you travel away from home for business the deduction for meals is an easy one. In fact, you can “make” money with meals deductions when you use a legal daily per diem and then you spend less than the per diem on food and incidentals while traveling. In addition, in the normal course of business, if a couple goes to dinner and discusses the business and they keep a record of what they talked about, the dinner can be deductible. I will caution you that husband and wife going out to dinner is probably not going to go over with the IRS when the business operates and files as a Schedule C (Form 1040). I lost some of you there, right? Just know that meals and entertainment involving a husband and wife that legitimately relate to business in an LLC or corporation are easier to justify. The cost of travel for business is deductible when we follow the rules.
Apart from vehicle expenses, the other big possible deduction is the home office deduction. When we run a business from our home, the costs related to the part of our home that we exclusively use for business can be deducted. A portion of our rent or mortgage, phone and utilities are all deductible against income that we have earned.
I’ve had people tell me that we shouldn’t take a deduction for our home office because it is something the Internal Revenue Service (IRS) looks at for audits. I have to shake my head. If we take the deduction by following the rules and if we keep records, why shouldn’t we take the deduction? If the IRS asks, we will give them the documentation. Let’s not give in to taxation by intimidation. Run our business. Keep records. Follow the rules. Earn some money. Manage our AGI. Reduce our taxable income. On the other hand, if you just like paying taxes and having no control over your AGI, then don’t change anything in your life.
When we operate our own business, we can legally take many expenses that are part of normal living and make them tax deductible above the line, to reduce AGI and taxable income. This is not a ‘loophole” in the tax law. Our government allows these deductions so that we have incentives to start businesses in the economy. For most households, managing AGI has the biggest impact of all when it comes to tax credits. There is an important difference between a tax deduction and a tax credit.
A tax deduction reduces taxable income and taxable income is the basis for figuring out how much tax we owe. A tax credit doesn’t reduce taxable income, it reduces the tax itself dollar for dollar. One of the important things about some tax credits is that even if we owe zero tax, we might get the tax credit in cash. If our tax credits are more than our income taxes, we could get the cash as a refund. By managing our AGI, we can qualify for tax credits for college students (parents of the student get the credit if they claim the student on their tax return). Two college credits are The Lifetime Learning Credit (up to $2,000 per year) and the American Opportunity Credit (up to $2,500 per year).
Controlling AGI can open the door to the Earned Income Credit (EIC). The amount of EIC changes with the number of qualifying children in the home. The credit ranges from about $500 per year to over $6,000 per year (with three children). The Child Tax Credit and health insurance Premium Tax Credit can represent thousands of dollars per year in tax reduction and tax benefits. If you are a college student or if you have college students in your family, AGI will determine how much they can receive for Pell Grants and other federal student aid and loans. Those benefits are worth thousands of dollars each year.
AGI. Above the line. Below the line. Itemized deductions. Taxable income. If our only income comes from our job, we have little or no control over AGI. We have limited ways to deduct expenses from our income. We are subject to higher tax brackets, we can lose our itemized deductions and personal exemptions, we lose access to valuable tax credits, we limit access to college finance options and other programs and we tend to increase our state income tax liability. Understanding AGI and learning to manage it by owning and operating a business is worth thousands of dollars per year in tax savings and other benefits. Make money from operating your business and at the same time, put more of your life “above the line” to keep more in your pocket.