- The American Rescue Plan sets new limits based on adjusted gross income (AGI) for a host of benefits.
- This tax form calculation, and modifications of it, has long been used to determine eligibility for certain tax breaks and federal benefits.
- There are strategies you can consider to help manage your income adjustments, depending on your priorities and needs.
Congress never quite boiled down the 1040 tax form to a postcard, but there is still one line that matters above all: adjusted gross income (AGI). That point will hit home for millions of Americans who qualified for previous rounds of stimulus but won't qualify for a host of benefits in the American Rescue Plan, which splits up nearly $2 trillion on a host of initiatives aimed at economic recovery based on new AGI levels. On the other hand, now all dependents qualify, whereas only those who were younger than 16 qualified before.
"People are looking at this through their own lens. Top of mind for many is whether you're going to get a check of up to $1,400 for each tax filer and dependent, but it depends on what your AGI was on your 2019 or 2020 tax returns," says Andy Vermilye, vice president of government relations at Fidelity.
Your adjusted income also matters for a new additional child credit for 2021, the taxability of enhanced unemployment, broadened access to health insurance premium subsidies under the Affordable Care Act (ACA), and several other components that put thresholds on benefits. The AGI limits on stimulus checks in the new law are stricter than in the previous COVID-relief bills, and actually end at the top of a narrow range rather than ratcheting down gradually. For instance, the income limits for single taxpayers to get $1,400 is $75,000 and that phases out to zero at $80,000.
This is not a new practice, of course. Adjusted gross income and the related modified adjusted gross income (MAGI) have long been the cornerstone for measuring eligibility for government and tax benefits, dating back to the 1986 Tax Reform Act, according to the National Association of Tax Professionals. Hard income thresholds are also fairly standard.
Think about how this works for the taxability of Social Security, if a senior has a part-time job that pushes them over the limit so their Social Security benefit suddenly gets taxed at the maximum amount. "Here they thought they were doing something great, but they just increased their tax liability," says Rhonda Collins, director of tax content and government relations of the National Association of Tax Professionals (NATP).
While most tax filers tend to focus on the bottom of the tax form, where you find the final calculations for tax due and any potential refund, those numbers come after you've already taken all your deductions and credits. Every tax return is a little bit different, so how much is left as taxable income varies greatly, depending on things like how many dependents you have, if you own a home or a business, and other offsets that can help reduce the total amount you owe.
At the top of the form, though, there is a short list of adjustments that reduce income before arriving at AGI, like a capital loss, and for 2020, a $300 charitable deduction if you take the standard deduction.
So using AGI, in a sense, reduces the financial variables of each individual's life. It is used to determine eligibility for the Earned Income Tax Credit, the Child Tax Credit, and the deductibility of health care expenses.
Some federal programs, like Medicare and the ACA (commonly known as Obamacare), base their calculations on what's known as modified adjusted gross income (MAGI), which adds back in certain deductions allowed for AGI. In addition, certain other tax-related thresholds depend on MAGI, including student loan interest deductions, Roth contributions, deductibility of traditional IRA contributions, the Lifetime Learning Credit, and several other tax credits. Note that MAGI is not a single value but several—some of the programs and thresholds listed above have MAGI definitions that differ slightly from the others. However, in all cases MAGI is higher than or equal to AGI.
The use of AGI and different forms of MAGI as measurements also extends beyond your annual tax return. When you file on behalf of your kids for college financial aid, for instance, your AGI will be a major factor in the way a school calculates your family's financial package. It even comes into play when you apply for consumer credit and loan products in the private sector or have any sort of interaction with a credit bureau.
Given the limited deductions available for adjusted and modified adjusted income, there's typically not a lot you can do to reduce your reported income once you get to the actual filing of your tax form. For example, if you're realizing now that you are over the limit for the new stimulus checks with both your 2019 and 2020 income, you can't go back and earn less.
However, there are strategies you can deploy designed to help manage the impact your income has on tax liabilities and other income-related financial events. You may want to pay close attention to this, especially if you know you are close to the limits of eligibility for certain programs, or if you are trying to manage your tax brackets overall, to reduce the amount you pay on the bottom line.
If you are an independent contractor, pay very close attention to the amount of income and deductions on Schedule C to make sure you qualify for things like the Earned Income Tax Credit, says Collins.
If you are a salaried employee, you may want to explore opportunities to defer income in some years and accelerate it in others, depending on the rest of your financial situation. There are various techniques for this, and though not available to everyone, they're worth investigating. They include the use of nonqualified deferred compensation (NQDC) and timing of the exercise of equity compensation/options, such as nonqualified stock options (NQSOs) and incentive stock options (ISOs).
If you are turning 72, you can push off taking your first required minimum distribution (RMD) until April 1 of the following year, if that helps you keep your income low in the current year. "But that only works for the first year you have to take a required minimum distribution, and will make your income higher the next year, when you have to take 2 distributions—both the delayed distribution and that current year’s distribution," says Matthew Kenigsberg, vice president of investment and tax solutions at Fidelity.
You can also consider a qualified charitable distribution (or QCD) for your RMD, which will lower your adjusted gross income. (Note that this contrasts with charitable contributions of taxable assets, which may reduce taxable income and income tax liability but do not reduce AGI.) And remember that if you do a Roth conversion, the pre-tax amount will be included in your AGI, so think about the timing and amount of Roth conversions carefully. It may be smart to delay or accelerate your Roth conversion, or time it to coincide with a QCD, for example.
"Strategies that focus on the timing of your deductions and of your income realization can help reduce your overall tax burden, so you can employ them even if you aren't trying to qualify for some specific program," says Kenigsberg.
The best strategy for you depends on your overall financial picture, so you should consult with a financial advisor and a tax professional to understand what's best for you.