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  • Writer's pictureGeorge Kao

Tax 101: Above & Below The Line


As we approach the tax deadline of April 15, everyone needs to know some ways to reduce their overall taxability. I wish someone had taught me some of these ideas when I was younger.


Why didn't anyone tell me this before?


As a financial planner, part of my job is to review my planning clients' tax situation and recommend and implement tax-saving strategies during the year.


When I was a youngster filing my own taxes, it would have been nice to know some of these strategies.


When I became a business owner, it would have been nice for someone to advise me on some of these strategies.


If you've been following me and my experience, you would know that my financial advisor for 20+ years never did any of this for me. Never did he ask for my tax return, and never did he make any recommendations. This is because he was a Bone Collector 🦴. He was not incentivized to go deeper into my situation than necessary because I was not a top asset-under-management client.


One of the main objectives when we're tax planning is to depress your AGI.


3 Ways to Lower Your Taxes

Let's begin by introducing the three ways the IRS allows you to lower your taxes.

  1. Adjustments - These are reductions made to your gross income before determining your Adjusted Gross Income (AGI). They offer a direct benefit by lowering your AGI, which affects various tax calculations. These are expenses you can claim without having to itemize your deductions.

  2. Deductions - These are expenses you can subtract from your income to lower your taxable income after calculating your AGI. You can choose to itemize (meaning listing them individually) or take the standard deduction, whichever is more beneficial.

  3. Credits - Unlike deductions, which reduce your taxable income from which the tax is calculated, credits directly reduce your tax bill dollar for dollar.



What is "The Line"?

"The Line" refers to your Adjusted Gross Income (AGI). This is a crucial number. Not only is the AGI your household income for the year, it is also used by lenders, credit issuers, the IRS, and many other entities. The AGI can be used to assess your "worthiness" to take on as a customer, your ability to repay debts, financial aid applications, or it can be used to categorize you into socioeconomic groups such as high-income earners or below the poverty line in order to qualify you for certain benefits.


Common places where your AGI is used:

  • Loan Documents (e.g., Mortgage, auto loan, personal loan)

  • Federal / State / Local Tax Calculations

  • Government Benefits

  • Credit Applications

  • Scholarships and College Financial Aid


One of the main objectives when we're tax planning is to depress your AGI as much as possible, thus lowering "The Line" as much as the tax law allows. To learn how to lower your AGI, we need to understand how the tax return is structured.



Parts of your Tax Return

Your tax return is generally made up of these parts:




As you can see, there is only one way to directly lower your AGI, and that is through Adjustments. Deductions and Credits are considered below "The Line," and although they are additional opportunities to lower your overall taxes owed, only Adjustments can lower your AGI.


Roth contributions are not tax-deductible...Therefore, your Roth contributions would not be counted as an adjustment, deduction, or credit.


Adjustments

So what are these Adjustments? Let's take a look at a Federal Tax Return 1040 to tell us more.


According to line 10 on the Form 1040, "Adjustments to Income" is devrived from Schedule 1. So let's take a look at Schedule 1 of the Federal Tax Return.


Page 1 lists "Additional Income" and page 2 lists "Adjustments to Income".



As you can see, Lines 11-24 (page 2) list all the adjustments you can take that will lower your AGI. Specifically, they are:

11. Educator Expenses

12. Certain business expenses

13. Health Savings Account

14. Moving expenses for military personnel

15. Self-employment tax

16. SEP, SIMPLE, and other qualified contributions

17. Self-employed health insurance premiums

18. Penalty on early retirement account withdrawals

19. Alimony paid

20. Deductible IRA contributions

21. Student loan interest deductions

23. Archer Medical Savings Account

24. Others


Each year, you want to ensure you use as many of these items in your tax return as applicable. For most people, the IRA contribution (Line 20) should apply. For small businesses, Lines 12 (business expenses), 15 (self-employment tax), 16 (business retirement contributions), 17 (self-employment health insurance) should apply also. If you're also on a high deductible health plan (HDHP), make sure you're contributing to the HSA (Line 13) to directly reduce your AGI even more.


The other items are less common, but be sure to review them to see if they apply to your situation.


Lastly, Roth contributions are not tax-deductible since they grow on a tax-free basis. Therefore, your Roth contributions would not be counted as an adjustment, deduction, or credit.



Deductions

Deductions are expenses that can be subtracted FROM your adjusted gross income (AGI) to determine your taxable income. Deductions are below "The Line." There are two ways to calculate deductions: standard deductions or itemized deductions. The standard deduction is a fixed amount determined by your filing status, while itemized deductions are specific expenses you claim on your tax return.


After the Tax Cuts & Jobs Act (TCJA) was passed in 2016 and took effect in 2018, the standard deduction levels increased. This allowed many more households to use the higher standard deductions rather than needing to itemize. Unfortunately, TCJA is set to sunset in 2025, reverting to the old standard deduction levels, and thus, more taxpayers will need to itemize in order to get the same level of deductions while TCJA was in effect. Things may change, so we must keep our eyes open for that.


To claim itemized deductions, you must have sufficient qualifying expenses to exceed the standard deduction for your filing status. Because of the higher standard deduction levels, most families will not have enough deductions to itemize. If you itemize, here are some common itemized deductions to include:

  • Mortgage interest: Interest payments on your home mortgage can be deducted if you itemize your deductions. With the TCJA, there's a limit to how much mortgage interest you can deduct.

  • State and local taxes: You can deduct state and local income or sales taxes, as well as property taxes.

  • Charitable contributions: Donations made to qualified charitable organizations can be deducted.

  • Medical and dental expenses: If your medical and dental expenses exceed a certain percentage of your AGI, you can deduct the excess amount. (notice AGI is used here!)

  • Miscellaneous deductions: These include expenses such as job search expenses, tax preparation fees, and investment-related expenses.


Contrary to popular belief, if you donate $100, you don't get to deduct $100 from your taxes. That's not how deductions work.

One more topic to cover regarding deductions: Charitable contributions

Your deductions plus your charitable contributions must exceed the standard deduction level before you can itemize your charitable contributions. Even if you itemize, the IRS limits the amount of charitable donations you can deduct based on your adjusted gross income (AGI). For cash donations, the limit is 60% of your AGI. For non-cash donations, the limit is typically 50% of your AGI, but it can be as low as 20% depending on the type of organization and the nature of the donated property.


Thus, contrary to popular belief, if you donate $100, you don't get to deduct $100 from your taxes. That's not how deductions work.



Credits

Credits are a dollar-for-dollar reduction of your tax liability. They are more beneficial than deductions in that they directly reduce the amount of tax you owe rather than reducing your taxable income. There are federal-specific tax credits as well as state-specific tax credits.

There are two main types of tax credits: refundable and non-refundable. Refundable tax credits can result in a tax refund if the credit amount exceeds your tax liability, while non-refundable tax credits can only reduce your tax liability to zero. Here are some specific examples of federal tax credits:

  • Earned Income Tax Credit (EITC) - This is a refundable tax credit for low- to moderate-income working individuals and families. The credit amount depends on your income, filing status, and the number of qualifying children you have.

  • Child Tax Credit - This is a partially refundable tax credit for families with qualifying children under the age of 17. For 2023, the credit amount is up to $2,000 per child, and there is also a $1,600 refundable amount for each child.

  • American Opportunity Tax Credit - This is a partially refundable tax credit for qualified education expenses incurred during the first four years of higher education. The credit is worth up to $2,500 per eligible student, and 40% of the credit is refundable.

  • Lifetime Learning Credit - This is a non-refundable tax credit for qualified tuition and related expenses incurred for undergraduate, graduate, and professional degree courses. The credit is worth up to $2,000 per tax return, and there is no limit on the number of years the credit can be claimed.

  • Saver's Credit - This is a non-refundable tax credit for low- and moderate-income individuals who contribute to a retirement plan, such as a 401(k) or IRA. The credit is worth up to $1,000 for single filers and $2,000 for married couples filing jointly.


Here in Arizona, we have something called STO (School Tuition Organization) which can be used to pay for tuition for private or charter schools. STO donations are Arizona-specfic tax credits where you get the dollar-for-dollar credit for your Arizona taxes.


These are just a few examples of tax credits that may be available to you, depending on your specific circumstances.


Conclusion

As you can see, the US tax system can get complex pretty quickly. But on a structural level, it is actually quite logical. With a basic understanding of the tax return, you can take the proper steps during the tax year to ensure you're maximizing your ability to reduce your taxes. This is the idea of tax planning. Every family's situation is unique, and business owners' taxes can get even more complicated. Equity-compensation and other passive income can complicate your taxes exponentially. Make sure you consult with a tax professional and/or a #RealFinancialPlanner who does tax-planning for their clients.


Interested in learning how tax-planning can help with your financial plan? Contact us today or Schedule a Meeting with us.







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