Steps to Cut Your Tax Bill

Dec. 12, 2007 — -- Last week, I advised readers to buy their tax preparation software now to help with year-end tax planning and lessen how much they owe the federal government in the spring.

One reason this purchase now is a good idea is that tax preparation software can make it easier to calculate your likely adjusted gross income for this year. Your adjusted gross income, or AGI, may be the most important figure on your personal tax return. AGI is used as the benchmark to determine your eligibility for a whole host of tax breaks, everything from tuition credits to medical expense deductions.

Once your AGI surpasses certain thresholds, your eligibility begins to phase out until it is eliminated entirely.

Located at the bottom of the first page on your federal tax return, adjusted gross income essentially is your total income from wages, investments, business profits and other sources minus certain adjustments.

Sometimes you might hear tax professionals talk about "above-the-line" or "below-the-line" deductions. The line they're talking about is the one just above adjusted gross income. Above-the-line deductions are considered particularly valuable because you do not need to itemize to claim these and they lower your AGI, thus increasing your eligibility for other tax breaks.

The bottom line is that knowing your AGI for the year will allow you to do a better job of tax planning and find ways to save you and your family money.

In that spirit, I've come up with a list I call "Five Reasons to Know Your AGI." It highlights tax breaks that are based upon your AGI. In some cases, the break is based on modified AGI, which generally is adjusted gross income increased by certain items. All figures are for 2007 as these numbers often are indexed for inflation.

For simplicity's sake, I include the AGI phase-out figures for married couples filing jointly and single persons. The limits for those classified as married filing separately and head of household may be different, depending upon the particular tax item.

Now, to our list: "Five Reasons to Know Your AGI."

The Roth IRA If you believe like I do that federal tax rates are likely to rise in the future, then contributing in a Roth IRA is a great move. Roth IRA contributions are paid with after tax dollars, but no taxes are due upon withdrawing the money in retirement after years of tax-free growth. Pay a little tax now to avoid owing more in the future. Not everyone, however, may contribute to a Roth IRA. On a joint tax return, Roth IRA eligibility begins to phase at modified AGI of $156,000 and is eliminated fully at $166,000 ($99,000 and $114,000 for singles).

Traditional IRA deductions If you participate in an employer-sponsored retirement plan, your ability to deduct contributions to a traditional IRA is limited by your income. For married couples, deductible IRA contributions begin to be phased out at $83,000 until reaching $103,000, at which point they are entirely phased out. For singles, the phase-out range runs from $52,000 to $62,000. There is separate phase-out range for married workers uncovered by a retirement plan, but whose spouses are. These folks can make a fully deductible contribution up to $156,000 AGI, and the deduction is eliminated entirely at $166,000.

Hope and Lifetime education credits These may be my favorite tax credits of all. They are designed to provide modest relief to families dealing with college tuition bills. The Hope credit applies to a student's first two years of college, providing up to $1,650 in tax relief per student. The Lifetime Learning Credit can be utilized at any stage of an academic career. The credit amount is equal to 20 percent of the first $10,000 in qualified higher education expenses per family, regardless of how many students in a family attend school simultaneously. That means a $10,000 tuition bill in 2007 will save you $2,000 in taxes if you meet the AGI guidelines. For both of these higher education credits, the married filing jointly phase-out range runs from $94,000 to $114,000 ($47,000 to $57,000 for singles).

Tax-free savings bond interest Let's continue with the education theme for a moment. Under the right conditions, U.S. Savings Bonds can be redeemed tax free if the proceeds are used for higher education expenses. As with the higher education credits, there are income limits, but, of course, they differ from those for the education credits. For married couples, the phase-out ranges from $98,400 to $128,400 (singles $65,600 to $80,600).

Personal exemption For 2007, the personal exemption for each member of your household amounts to $3,400 per person. The exemption is the equivalent of a $3,400 deduction, but the exemption is reduced if you're a high-income earner. The range for the personal exemption phase-out runs from AGI of $234,600 to $357,100 for married couples, but in no case is there a complete phase-out. For 2007, at most, the lost exemption amount is two thirds of the $3,400. The singles phase-out range is $156,400 to $278,900.

I could continue with more examples related to medical deductions, retirement savings credits and other tax issues, but you get the idea. Adjusted gross income is critical to figuring out which tax breaks you receive. Knowing yours can help save you money and invest for the future.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com