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It’s a new year, and all thoughts eventually turn to taxes. January is the perfect time to understand last year’s tax implications and plan your strategy… for next year.
Often when one thinks of how to write a smaller check (or get a larger refund) on April 15th, the emphasis is on tax deductions.
The reality is that, according to the Tax Policy Center, almost 90% of tax filers now use the standard deduction.
The 2017 increase in the standard deduction means the typical non-business-related deductible expenses (mortgage interest, state and local taxes, charity) are less useful as itemized deductions.
For most W-2 wage earners, paying less in taxes is not about finding obscure deductible expenses but rather declaring less taxable income.
The actions you need to take for that strategy to work are best decided upon before the first hints of spring.
Taxes on Your Income
First a few important definitions:
- Adjusted Gross Income (AGI) – Your gross income from wages, tips, dividends, capital gains, business income, retirement distributions, and certain other income, minus adjustments, such as student loan interest, educator expenses, and contributions to a retirement account or health savings account.
- Modified Adjusted Gross Income (MAGI) – Your calculated AGI plus certain deductions added back.
- Interest on student loans
- Qualified tuition expenses
- Tuition and fees
- 1/2 of self-employment tax
- Rental losses
- Passive loss or passive income
- IRA contributions
- Non-taxable social security payments
- Other rare deductions such as the exclusion for income from U.S. savings bonds, foreign earned income exclusion, foreign housing exclusion or deduction, and the exclusion under 137 for adoption expenses
- Marginal Tax Rate – the amount of additional tax you pay for higher levels of income you earn.
Your MAGI affects your eligibility to take certain deductions or receive specific subsidies, i.e., retirement or health savings account contributions.
A lower MAGI on your 1040 tax form equates to lower tax liability. Your starting point is to be mindful of the difference in marginal tax rates.
For taxable income earned in 2022, the table below applies:
|Rate||For Unmarried Individuals||For Married Individuals Filing Joint Returns (MFJ)||For Married Individuals Filing Separately||For Heads of Households|
|10%||Up to $10,275||Up to $20,550||Up to $10,275||Up to $14,650|
|12%||$10,276 – $41,775||$20,551 – $83,550||$10,276 – $41,775||$14,651 – $55,900|
|22%||$41,776 – $89,075||$83,551 – $178,150||$41,776 – $89,075||$55,901 – $89,050|
|24%||$89,076 – $170,050||$178,151 – $340,100||$89,076 – $170,050||$89,051 – $170,050|
|32%||$89,076 – $170,050||$340,100 – $431,900||$89,076 – $170,050||$170,051 – $215,950|
|35%||$215,951 – $539,900||$431,901 – $647,850||$215,951 – $323,925||$215,9511 – $539,900|
|37%||Over $539,900||Over $647,850||Over $323,925||Over $539,900|
For a single person with income in 2021, the 12% marginal tax rate applies up to $40,525, jumps to 22% for income from $40,526 up to $86,375, and then nudges up to 24% until you reach $164,925.
It's only after that when you jump to the 32% tax bracket or higher. Double these income figures for Married Filing Jointly (MFJ) taxpayers.
The amount of your income falling within the brackets is taxed at the corresponding tax rate.
- Example: If you’re single and have $56,789 in taxable income for 2022, you’ll pay
- 10 percent on the first $10,275 = $1,027.50
- 12 percent on earnings from $10,276 to $41,775 = $3,779.88
- 22 percent on earnings from $41,776 to $56,789 = $3,302.86
- Total tax = $8,110.24 ($1,027.50 + $3,779.88 + $3,302.86)
Because tax income bands are wide, managing your taxable income to stay at a particular tax rate is probably not going to be your predominant strategy to lower your tax bill.
But if you anticipate being on the bubble between brackets, then it may be worthwhile to engage in a bit of taxable income management, as discussed below. (I do not mean earning less!)
Perhaps more usefully, reporting a lower MAGI can make it possible to benefit from income-limited tax credits.
(A primer: A tax credit is far better than a tax deduction. A tax credit lowers your tax payment, dollar for dollar, by the amount of the credit.)
Saving With Tax Credits
Here are a few examples of the most valuable tax credits:
· The American Opportunity Tax Credit is particularly useful for parents who are paying college tuition for their children. You can receive a credit of up to $2,500 per student. To claim the full credit, your income must not exceed $80,000 ($160,000 MFJ).
· The Lifetime Learning Credit is helpful if you or a dependent are enrolled in a non-degree program or enrolled less than halftime. This credit can be worth up to $2,000 per tax return, phasing out entirely for incomes beyond $69,000 ($138,000 MFJ).
· If you care for a child under age 13 or another person who is disabled, the newly expanded Child and Dependent Care Credit can offset some of your expenses. To take full advantage of this credit, your household income must not exceed $125,000. The benefit phases out completely for incomes over $400,000.
· The Child Tax Credit is a bit of a moving target as of this writing. Suffice to say that your MAGI limits your ability to benefit from this important tax benefit. As it currently stands, the $2,000 per child credit begins to phase out for incomes over $200,000 ($400,000 MFJ); there may be other, lower income limits for additional benefits.
Did you purchase health insurance through the Health Insurance Marketplace?
If so, the premium you pay may be reduced by the Premium Tax Credit.
The calculation is more complex than the credits above; however, you can ballpark your Premium Tax Credit using this tool from the IRS.
You are generally eligible for credit so long as your MAGI does not exceed 400% of the federal poverty line for your family size.
There are other non-credit tax benefits to a lower MAGI as well:
Long term capital gains in 2022 are taxed at 0% for incomes below $41,657 or $83,350 MFJ (2021 – $40,400 or $80,800 MFJ), 15% up to $459,750 or $517,200 MFJ (2021 – $445,850 or $501,600 MFJ) and 20% thereafter.
Short term capital gains are taxed at your ordinary marginal income tax rate.
If you have substantial capital gains, it makes sense to know how your reported income affects the taxation of those gains.
Also, you can take a deduction for the amount you pay in student loan interest (up to $2,500) on your taxes, even if you use the standard deduction. But your ability to do so ends when your MAGI exceeds $70,000 ($140,000 MFJ).
Lowering Your MAGI
If you’re now convinced to seek ways to lower your MAGI, how can you accomplish that?
Optimize your retirement savings strategy
· The most obvious starting point is a traditional (pretax) retirement plan. Contributions to a tax-deferred retirement plan lower your taxable income.
Unlike an IRA, your ability to participate in a 401(k) is not limited by your income, and the annual allowable contribution amounts are far higher.
According to Fidelity, younger investors are especially fond of the Roth (after-tax) retirement account option.
However, if all your retirement savings are made after-tax, take a moment to consider if you’re passing up the opportunity for valuable tax savings today.
Once you’re actually in retirement, the script flips quite a bit.
At the point in your life when you’re taking distributions from your retirement accounts, a Roth-type account is your best friend as this stream of income is not reported as taxable income.
A lower MAGI means less of your Social Security benefit will be taxable.
For high income households, there’s a surcharge for Medicare Part B coverage when your income exceeds $91,000 ($182,000 MFJ).
Being “tax diversified” within your investments during retirement will allow you to manage your annual tax payment.
As you see, comparing your marginal tax rate today to the projection of your future tax rate is only part of the “Which type of retirement account is best?” calculation.
Utilize Other Savings Accounts
· Contribute to a Health Savings Account (HSA). HSAs are another popular way to lower the amount of income tax you pay today, as these contributions are made pre-tax.
If having a high deductible health insurance plan makes sense for you, in 2022, as an individual, you can put as much as $3,650 per year into an HSA, rising to $7,300 for a family.
Those 55 or older this year, can put in an extra $1,000 in “catch up” contributions.
Withdrawals from the account for qualified medical expenses are not taxed or penalized at any age.
Once you're 65 years old, you can make a withdrawal from your HSA for any purpose without penalty…but it will be considered taxable income.
· Consider a Flexible Spending Account (FSA). While not as generous as an HSA, contributions to a healthcare FSA or a dependent care FSA are pre-tax, lowering your tax liability.
However, the balance in an FSA is “use or lose”; you must generally expend it on qualified expenses by the end of the calendar year or shortly thereafter.
What’s the bottom line?
You may want to have a foot in both camps:
- “managing down” your taxable income in years when there's a possibility of gaining a significant tax credit or other benefits
- placing greater emphasis on after-tax investing in other years
That way, you’ll have the option of tax-free income in the future. Who said taxes were simple?
Article written by Lisa Whitley, AFC®, CRPC®.
Lisa enjoys having money conversations every day with people from all backgrounds. After a long career in international development, she brings a cross-cultural dynamic to her current work to help individuals and families achieve financial wellness.