Practical Cents #8: Your Income Explained

Hello everyone, and thank you for joining me. We're closing in on the tax filing deadline, so even more than usual, I appreciate you taking the time to watch this. This also means you're now hearing terms used only during this time of year that you likely need to refamiliarize yourself with, terms like adjusted gross income, modified adjusted gross income, and taxable income. They sound similar, but they're all different and have a different impact on your taxes and the planning around them. So, let's dive in.

To start, let's take a look at adjusted gross income, otherwise known as AGI. A good way to think about AGI is that it is the total of all the income sources that can be taxed. This includes things like your wages, retirement account distributions, capital gains, taxable Social Security, and taxable interest and dividends. AGI serves as the starting point of your income tax return. So, when you hear things like pre-tax retirement account contributions, HSA contributions, or tax-exempt interest being ways to reduce your income, they're excluded from your adjusted gross income. But that does not mean they're not a factor at all, and brings us to our next term.

Modified adjusted gross income, or MAGI, one additional word, but a whole lot of difference. MAGI takes all those income sources we just took a look at and then adds back certain items that don't show up, such as tax-exempt interest, deductible IRA contributions but not employer plan contributions, and student loan interest. Most critical of these is the tax-exempt interest. While you're not paying taxes on it, it can have a big impact. And for those of you close to 65 or 65 and older, pay close attention here: MAGI is the amount used to determine Medicare surcharge premiums, also known as IRMAA. So even though the interest is tax-free, there may still be a cost.

However, on the bright side, we've now gotten to the place on your income tax return where you're going to get a deduction to determine and lower the amount of your taxable income, the amount of income you're actually paying tax on, and the rate at which it is being taxed. To start, let's look at the deduction. Your deduction amount is the higher of the standard deduction, the one for just being a taxpayer, or itemized deductions, the total of things like mortgage interest, state and local taxes, and charitable contributions made in the previous calendar year. And as a quick reminder, certain income sources like capital gains are taxed differently and are lower than regular income sources like retirement account distributions. And as another reminder, the rate at which these income sources are taxed is what's called progressive, meaning that as your taxable income increases, the tax rate becomes higher. But not all your income is taxed at the highest bracket, just the next dollar once you cross into the next bracket.

So, now what? As you either finalize your return or file an extension, this time of year can be great to reflect on the previous one, but more importantly, plan ahead for the next one. And ask yourself or your advisor: what income and tax planning techniques can effectively be done for my situation? What, if any, are some ways I may be able to lower my lifetime taxes? Are there any unique situations this year that may need to be planned for? At Presilium, we review our clients' previous year's tax return to answer questions like these and deliver proactively on strategic planning for the years ahead. If that's something missing from your experience, let's get in touch. Thanks for watching and until next time.