Strategies to Reduce Your Adjusted Gross Income Guide

Reducing your Adjusted Gross Income (AGI) is a key strategy for lowering your overall tax burden. Your AGI, found on line 11 of your federal Form 1040, is a crucial figure that impacts various aspects of your tax return. This comprehensive guide explores multiple ways to lower your AGI, from maximizing contributions to employer-sponsored retirement plans and IRAs to leveraging Health Savings Accounts (HSAs) and Flexible Spending Accounts (FSAs). Whether you’re a W-2 employee or self-employed, understanding these AGI reduction techniques can help you minimize taxable income and potentially increase your tax refund.

Understanding Adjusted Gross Income (AGI)

Adjusted gross income, or AGI, is what is calculated right before you take either your itemized deductions or the standard deduction. If you filed in 2020, your AGI is listed on line 11 of your federal form 1040. This number represents all of your income, including wage income, self-employment income, interest and dividends and any other sources, less any “above-the-line” deductions.

The lower your AGI is, the lower your taxable income will be, and therefore the lower your taxes will be! Obviously, everyone wants to pay less in taxes, and reducing your AGI is really the biggest and best way to lessen your tax burden. Below, we’ll go over the five biggest deductions (plus a bonus one!) that you can use to reduce your AGI.

1) Employer-Sponsored Retirement Plans: The Top AGI Reducer

There is probably no greater option for individuals to reduce their AGI than using a 401(k) or another type of tax-deferred retirement plan. A large part of this is because deferrals to retirement accounts like a 401(k) are not included in your reported wages at all. Most of the other options on this list begin with your wages as reported on line 1 of the 1040 and are subtracted from there. Retirement contributions are not even included on line 1 of the 1040. This has the added benefit of reducing your starting point for all other deductions on this list. If there is one strategy to pick to reduce your AGI, this should be it.

Retirement plans also tend to be where you can take the largest deduction. You can defer up to $20,500 from your income in 2022. If you are over 50 years old, you can also make “catch-up contributions” of up to an additional $6,500 for a total deferral of $27,000. Depending on your work situation, your employer may be able to contribute additional amounts. If you have a SIMPLE 401(k), you will be limited to $14,000 (with a $3,000 catch-up contribution amount).

2) IRAs: Another Powerful Tool to Lower AG

You can contribute to an IRA even if you are covered by a retirement plan at work. In 2022, an individual can contribute up to $6,500 to an IRA. This is a particularly good option for individuals who have a SIMPLE 401(k) and are limited to lower contribution amounts on their 401(k) option. If you are over 50 years old, you again are able to make catch-up contributions of up to an additional $1,000 in 2022. However, there are strict limitations on the amount of contributions you can deduct based on your AGI, so stacking with a 401(k) to reduce your starting income can be a good idea.

3) HSA and FSA Contributions: Dual Benefits for Health and Taxes

Health savings accounts (HSAs) and flexible spending accounts (FSAs) are great options to reduce your AGI while also providing concrete benefits. Both have contribution limitations that are dependent on the type of account you have.

An HSA can be a powerful option for younger, healthy individuals. Your health insurance plan must be a high-deductible plan (meaning your deductible must be at least $1,400 for solo plans and $2,800 for family plans). If your coverage is only for you, you can contribute up to $3,650 to an HSA for 2022. If you have family coverage, you can contribute up to $7,300 for the year.

HSAs are very similar to IRAs. You contribute amounts to the account and do not pay taxes on those contributions. However, unlike a retirement account, you do not pay taxes on the distributions from the account, so long as you spend the money on medical expenses. Similar to IRAs, once you reach a certain age you can make additional contributions to these accounts. Once you reach 65, any distributions made from the accounts are penalty free regardless of whether they are for medical expenses — though non-medical expenses will be subject to ordinary tax.

FSAs are not quite as beneficial as HSAs, but they are a good option for individuals who do not want a high-deductible plan. With an FSA, you can contribute up to $2,850 for an individual plan or up to $5,000 for a dependent care FSA. The amounts generally do not roll over or accumulate, so they are “use or lose.” Employers may allow a three-month grace period to use the full amounts contributed or a rollover amount of $570. Certain COVID-19 relief provisions extended grace periods and contribution limits for some types of FSAs, but these have expired at this point.

4) Self-Employment Deductions: Reducing AGI for Business Owners

Depending on how you are employed, your health insurance premiums may either be deductible on your 1040 or not be reported at all in your wages. Many employer plans under section 125 of the Internal Revenue Code (often referred to as “cafeteria plans”) have health insurance benefits that reduce your reported taxable wages on your W-2. This can include health insurance, vision coverage and dental insurance.

If you are self-employed and file a Schedule C, these premiums are deductible on your individual return. You can deduct the full amount of health insurance costs less any premium subsidies you received on your Schedule C. This reduces your overall compensation and therefore your AGI. If you purchased health insurance and you are not self-employed, you can only deduct the cost of health insurance premiums if you itemize your deductions and your total medical costs exceed 7.5% of your AGI — so it won’t reduce your AGI the way other options will.

5) Self-Employment Tax Deduction

If you are self-employed, you are likely very familiar with the self-employment tax. While W-2 employees are subject only to a 6.2% social security tax and a 1.45% tax for medicare, self-employed individuals are on the hook for all 15.3% of these taxes. However, to soften the blow at least a little bit, Congress allowed for a deduction of these taxes to reduce AGI and therefore taxable income. This can be a confusing calculation for individuals, so consulting with your tax advisor can be very beneficial.

Additional AGI Reduction Strategies: Health Insurance and Student Loan Interest

The student loan interest deduction is, quite frankly, not much, but something is always better than nothing! If your AGI is under $70,000 ($140,000 if married filing jointly), you can take the full deduction of $2,500. The deduction is phased out based on your AGI, with no deduction allowed if your AGI is above $85,000 ($170,000 if married filing jointly). No deduction is allowed if you are married and filing separately. Unlike many deductions, the amount you can deduct is the same whether you are filing as single or married.

All of these are great ways to significantly reduce your AGI and therefore your tax bill. You can stack many of these deductions to reduce your total AGI. Starting with deductions that are taken directly from your wages, such as 401(k) or HSA contributions or health insurance costs, will help you maximize the benefits. Your tax advisor should be able to help you make the most of your deductions and advise you on the best plan of action.