Numerous tax breaks (tax credits, deductions, and other tax benefits) are reduced or eliminated if a taxpayer’s adjusted gross income (AGI), or modified AGI, exceeds specified thresholds. As year-end nears, taxpayers who otherwise qualify for these tax breaks should try to modify or reduce 2014 AGI using some techniques that we will explore in this article.
Some of the tax breaks that depend on AGI are the following:
For 2014 and 2015, an individual may make a nondeductible Roth IRA contribution of up to $5,500 and up to $6,500 if 50 or older, reduced by any amount contributed to a traditional IRA, but the deduction phases out ratably for modified AGI between $181,000 and $191,000 in 2014 ($183,000 and $193,000 in 2015) for joint filers, between $114,000 and $129,000 for 2014 ($116,000 and $131,000 for 2015) for single filers and persons filing as head of household, and between $0 and $10,000 for both 2014 and 2015 for married people who file separately.
For 2014, the AGI phase-out for making deductible contributions to traditional IRAs by taxpayers who are active participants in an employer-sponsored retirement plan begins at $96,000 of modified AGI for married filing joint and the deduction is phased out completely at $116,000 of modified AGI ($98,000 and $118,000 for 2015). For single taxpayers or those filing as head of household, the phase-out begins at $60,000 of modified AGI and is phased out completely at $70,000 of modified AGI ($61,000 and $71,000 for 2015). For both 2014 and 2015, for those filing as married filing separately, the otherwise allowable contribution phases out ratably for MAGI between $0 and $10,000.
For a married taxpayer who is not an active plan participant in a retirement plan, but whose spouse is participant in a plan, the otherwise allowable deductible contribution will be phased out ratably for 2014 for MAGI between $181,000 and $191,000 (between $183,000 and $193,000 for 2015).
Taxpayers are allowed a $1,000 child tax credit for each qualifying child under age 17. The amount of the credit allowable is reduced by $50 for each $1,000 (or part of a $1,000) of modified AGI above $110,000 for joint filers, $75,000 for single filers, and $55,000 for married filing separately.
For 2014 and 2015, qualifying taxpayers may claim an American Opportunity Tax Credit or AOTC (formerly the Hope credit). There’s also a Lifetime Learning Credit per qualifying taxpayer. The credits are for qualifying higher education expenses at accredited post-secondary educational institutions paid for themselves, their spouses and their dependents. For 2014 and 2015, the AOTC is an amount equal to 100% of qualified tuition and related expenses not in excess of $2,000 plus 25% of those expenses in excess of $2,000, but not in excess of $4,000. Accordingly, the maximum AOTC for tax year 2014 or 2015 is $2,500 for each eligible student. For 2014 and 2015, the otherwise allowable credit is reduced by the amount that bears the same ratio to the credit as the excess of the taxpayer’s MAGI over $80,000 ($160,000 for a joint return) bears to $10,000 ($20,000 for a joint return. For 2014 and 2015, the per-taxpayer Lifetime Learning credit equals 20% of up to $10,000 of qualified tuition and related expenses paid during the tax year, for a maximum credit of $2,000. For 2014, the credit is phased out ratably for taxpayers with MAGI from $54,000 to $64,000 ($108,000 to $128,000 for marrieds filing jointly). For 2015, the credit is phased out ratably for taxpayers with MAGI from $55,000 to $65,000 ($110,000 to $130,000 for married filing jointly).
Individuals may take an above-the-line deduction for up to $2,500 of interest on qualified education loans, but, for 2014 and 2015, the amount otherwise deductible is reduced ratably at modified AGI between $130,000 and $160,000 on joint returns, and between $65,000 and $80,000 on other returns.
Taxpayers may contribute up to $2,000 annually to a tax-exempt Coverdell Education Savings Account (CESA) for an individual under age 18 (and special needs beneficiaries of any age). For contributors who are individuals, the maximum contribution for 2014 or 2015 is reduced ratably for modified AGI between $190,000 and $220,000 for joint filers, and between $95,000 and $110,000 for others.
For 2014, the tax-free break for interest on U.S. savings bonds redeemed to pay qualified higher education expenses phases out beginning at MAGI $76,000 ($113,950 on a joint return). For 2015, the phase-out will begin at MAGI above $77,200 ($115,750 on a joint return).
An individual is allowed a credit against income tax (and AMT) for qualified adoption expenses. The total expenses that may be taken as a credit for all tax years with respect to the adoption of a child by the taxpayer is $13,190 for 2014 ($13,400 for 2015). For 2014, the credit for the adoption of a special-needs child is $13,190, regardless of the extent to which the taxpayer has qualified adoption expenses ($13,400 for 2015). For 2014, the credit begins to phase out at AGI of $197,880 ($201,010 for 2015). The phase-out is complete at $40,000 above the applicable threshold.
A limited amount of non-passive income can be offset by passive losses from an active participation rental real estate activity. The $25,000 ceiling on this tax break begins to phase for those with adjusted gross income (subject to some special modifications) in excess of $100,000 and is completely phased out at AGI of $150,000
Other AGI-related tax items:
There are other items of income, deduction, credit, and exclusion that are affected by levels of AGI or modified AGI. Key items affected are:
itemized deductions, phase-out begins at higher AGI limits;
the Medicare contribution tax of 3.8% on net investment income, This Net Investment Income Tax (NIIT) is a tax on investment income for taxpayers whose AGI is $250,000 or more;
miscellaneous itemized deductions, subject to 2% of AGI;
Social Security benefits taxation;
medical expense deduction, subject to 10% of AGI; and
non-business casualty loss deductions.
How to adjust your AGI
Not all the steps listed below will be available or desirable for every individual, but many whose income without any planning would be in the range of a threshold may be able to use one or more of the following strategies to keep AGI below the applicable level:
Convert taxable interest to tax-exempt interest. This will be especially practical where an individual will recognize little or no gain on the disposition of a taxable investment, such as when shifting funds in a taxable money market account to a tax-exempt fund. The tax-exempt interest will not be included in AGI (except in determining the taxability of Social Security benefits), and for some individuals, the after-tax amount received from tax-exempt interest might be at least as much as the after-tax amount received from taxable interest. That’s especially true if the tax-exempt interest is exempt from state or local income taxes as well as from Federal income tax.
Caution: Taxpayers who might be subject to the alternative minimum tax should not invest in tax-exempt private activity bonds since the interest on those bonds is included in determining alternative minimum taxable income.
Convert taxable interest to tax-deferred interest or income. Instead of leaving funds in a savings or money market account generating taxable interest, some individuals may want to shift some funds to U.S. Series EE bonds or inflation-indexed U.S. Series I savings bonds. Unless the individual elects otherwise, “interest” on Series EE or I bonds isn’t taxed until the bonds mature or are redeemed. Another possibility would be to buy Treasury Bills with a term of one-year or less that mature in 2015 so that the income from the Bills won’t be included in gross income until that year. Alternatively, individuals may shift funds from investments that produce currently taxable income to growth stocks, which pay little or no dividends and give the individual the ability to control when any gain on the stocks will eventually be realized by timing their sale to suit his tax goals.
Pay off debts. If an individual has both income-generating investments and debts on which he is paying interest, he should consider selling part of his investments and using the proceeds to pay off debt. In addition to reducing AGI, this may increase the individual’s net income because the reduction in interest payments often is greater than the reduction in the income received on the investment.
Increase contributions to 401(k) plans, SIMPLE pension plans, etc. Some individuals may be able to reduce AGI by increasing contributions to retirement plans such as 401(k) plans, SIMPLE pension plans, and Keogh plans.
Illustration: Jenna has compensation income above $100,000 and usually makes elective deferrals of $5,000 a year to the 401(k) plan maintained by her employer. For 2014, Ellen doubles her elective deferral amount to $10,000, effectively making her 2014 and 2015 contributions in 2014. This will reduce her 2014 AGI by $5,000 more than her normal 401(k) contribution would.
Caution: Assume an employer makes matching contributions to a 401(k) plan at one rate for elective deferrals up to a certain percentage of compensation and doesn’t match (or matches at a lower rate) for elective deferrals of greater percentages of compensation. Doubling up contributions will cause the employee to lose some employer matching contributions, unless the employee also makes his usual contribution for 2015 in addition to doubling up for 2014.
Increase contributions to health savings account (HSA). Individuals who are covered by a qualifying high deductible health plan (and are generally not covered by any other health plan that is not a qualifying high deductible health plan) may make deductible contributions to an HSA, subject to certain limits. For calendar year 2014, assuming a full year of coverage, the maximum contribution is $3,300 for self-only coverage and $6,550 for family coverage ($3,350 and $6,650 for 2015), plus an additional $1,000 for those age 55 or older. Distributions from an HSA to pay qualified medical expenses are not taxable. Distributions used for nonmedical purposes are taxable, and if made before age 65, are subject to a 10% penalty tax. An individual’s HSA contribution level may be based on expected out-of-pocket medical expenses, but there is nothing to prevent an individual from making deductible contributions up to the maximum allowable, regardless of expected expenses. These contributions in excess of medical needs can be withdrawn from the HSA and used for any purpose without penalty (but subject to tax) once the individual reaches age 65.
Defer receipt of year-end bonuses. An employee who believes a bonus may be coming his way may request that his employer delay payment of any bonus until early in the following year. For example, if a bonus would normally be paid on Dec. 15, 2014, an employee may ask the employer before Dec. 15 to defer any bonus coming his way until January 2, 2015. By deferring the bonus, the employee will avoid having it included in 2014 income
Caution: If an employee waits until a bonus is due and payable to request a deferral, the doctrine of constructive receipt will be triggered and the tax on the bonus will not be deferred. Also, if the deferral extends beyond two-and-one-half months after the close of the tax year, the bonus will be treated as nonqualified deferred compensation. Bonuses treated as nonqualified deferred compensation are currently includible in income to the extent not subject to a “substantial risk of forfeiture” if the arrangement fails to meet certain distribution, acceleration of benefit, and election requirements.
Caution: The impact of the Social Security part of the FICA tax may also affect the timing of a bonus. For example, if an employee is retiring in 2015, the employee’s salary alone may exceed the Social Security wage base in 2014 ($117,000) but not in 2015. As a result, postponing a bonus payment from 2014 to 2015 could convert a bonus exempt from the Social Security tax into a bonus subject to that tax.
Take capital losses in 2014. Taxpayers with unrecognized capital losses should consider taking them in 2014 to reduce AGI by offsetting capital gains and $3,000 of ordinary income if capital losses exceed capital gains by at least that amount. This will be especially helpful if the individual can arrange to offset up to $3,000 of long-term capital losses against ordinary income in 2014 instead of using them to offset long-term capital gain. Also, since capital gains are included in net investment income for purposes of the 3.8% surtax on net investment income, taking capital losses to offset capital gains may reduce the tax or eliminate it completely if MAGI is reduced below the threshold at which the surtax is imposed.
These are just some strategies that can be implemented by individuals to reduce AGI in 2014.