Question

How does investing and extra deductions from taxpayers contribute to a lower AGI (remember back to 401K plans)? Are the withholding and extra deductions worth the taxpayer investing?

Answer 1

Adjusted igross iincome i(AGI) iis ia imeasure iof iincome icalculated ifrom iyour igross iincome iand iused ito idetermine ihow imuch iof iyour iincome iis itaxable. iIt iis ithe istarting ipoint ifor icalculating ia ifiler's itax ibill iin ithe iUnited iStates iand, iamong iother ithings, iis ithe ibasis ifor imany ideductions iand icredits. iWhen ifiling iyour itaxes ionline—as iabout i90% iof ifilers ido—the isoftware iyou iuse iwill icalculate iyour iAGI ifor iyou.

AGI iis ia imodification iof igross iincome iin ithe iUnited iStates itax icode. iGross iincome iis isimply ithe isum iof iall ithe imoney ian iindividual iearns iin ia iyear, iwhich imay iinclude iwages, idividends, ialimony, icapital igains, iinterest iincome, iroyalties, irental iincome, iand iretirement idistributions. iAGI ifactors iin ia inumber iof iallowable ideductions ifrom iyour igross iincome ito ireach ithe ifigure ion iwhich iyour iincome itax iliability iwill ibe icalculated. iAGI iand inet iincome iare itwo idifferent ithings, ithough ithe iterms iare isometimes iused iinterchangeably.

The ideductions iyou itake ito icalculate iAGI iare ireferred ito ias iadjustments ito iincome. iSome iof ithe imost iprominent ideductions imade ito ireach ian iindividual’s iadjusted igross iincome iinclude:

1. Certain iretirement iplan icontributions, isuch ias iindividual iretirement iaccounts i(IRA), iSIMPLE iIRA, iSEP-IRA, iand iqualified iplans

2. Half iof ithe iself-employment itax

3. Healthcare isavings iaccount i(HSA) ideductions

4. Alimony ipaid i(included iin ithe irecipient's igross iincome)

5. Moving iexpenses i(but isince i2018, ionly iif iyou're iactive-duty imilitary imoving idue ito imilitary iorders)

6. Losses iincurred ifrom ithe isale ior iexchange iof iproperty

7. Early-withdrawal ipenalties ilevied iby ifinancial iinstitutions

8. School ituition, ifees, iand istudent iloan iinterest i(exceptions iand ilimits iusually iapply)

9. Jury iduty ipay iturned iover ito ia ifiler's iemployer

10. Some ibusiness-related iexpenses iincurred iby iperforming iartists, iteachers, ifee-basis igovernment iofficials, iand ireservists

Traditional i401(k) icontributions ieffectively ireduce iboth iadjusted igross iincome i(AGI) iand imodified iadjusted igross iincome i(MAGI). iParticipants iare iable ito idefer ia iportion iof itheir isalaries iand iclaim itax ideductions ifor ithat iyear. iA iRoth i401(k), isimilarly ito ia iRoth iIRA, iis ifunded ithrough iafter-tax idollars iand ioffers ino iimmediate itax ideduction.

Traditional i401(k) iplan icontributions iare inot iconsidered ito ibe ideductions ion ia i1040 itax ireturn, ilike ia icontribution ito ia itraditional iIRA. iTo icontribute ito ia i401(k), ian iemployee imust ibe ieligible iand ithe iemployer imust ioffer isuch ia iplan. iThen, ian iemployee imay ibegin ideferring ia ipercentage iof ihis isalary itoward ithat iplan ithroughout ithe iyear. iAny iamount icontributed ito ithe iplan iup ito ithe iIRS ilimit iis iconsidered ia ireduction iof ithat iemployee's itaxable iwage.

In i2019, ithe imaximum icontribution ilimit iwas i$19,000, iand ithose iage i50 ior iolder iwere iable ito icontribute ia i"catch-up" iamount iof ian iadditional i$6,000. i(For i2020, ithe imaximum icontribution ilimit iis i$19,500 iand ithe icatch-up iamount iis i$6,500.) iFor iexample, iif ia i40-year-old iemployee iwho imakes ia i$100,000 ia iyear isalary icontributes ithe ifull iamount iof i$19,500, ithe ireported iincome ifrom ithe iemployer ishows i$80,500. iThe ioriginal icontribution iof i$19,500 iis ideposited iinto ithe iemployee's iown ipersonal i401(k) iplan ito ibe iinvested iwithin ithe iplan's ioptions. iThe iemployee iis itaxed ionly iwhen ithe ifunds iare idistributed ifrom ithe i401(k) iplan ior ifrom ia ifuture irollover iIRA.

Traditional i401(k) iplans iare ivery iattractive ifor iindividuals ilooking ito ireduce itheir iAGI/MAGI. iThe ipotential iof itax ideferral iand ireduction iof icurrent itaxable iincome ioffer iways ito ireduce itax iliabilities. iMany ihave ialso ifound ithis ia ibetter ioption ithan ia itraditional iIRA idue ito ithe imaximum iannual icontribution ibeing ilimited ito ionly i$6,000, iwith ia i$1,000 icatch-up. i(This iamount iis ithe imaximum ifor iboth i2019 iand i2020.) iIf iyou iare iinterested iin icontributing ito iyour iemployer's i401(k) iplan, icontact iyour iplan isponsor ior ihuman iresources idepartment. iFor imore itax istrategies, iconsult ia itax ior ifinancial iadvisor.

Answer2.

A iwithholding itax iis ian iamount ithat ian iemployer iwithholds ifrom iemployees’ iwages iand ipays idirectly ito ithe igovernment. iThe iamount iwithheld iis ia icredit iagainst ithe iincome itaxes ithe iemployee imust ipay iduring ithe iyear. iIt ialso iis ia itax ilevied ion iincome i(interest iand idividends) ifrom isecurities iowned iby ia inonresident ialien, ias iwell ias iother iincome ipaid ito inonresidents iof ia icountry. iWithholding itax iis ilevied ion ithe ivast imajority iof ipeople iwho iearn iincome ifrom ia itrade ior ibusiness iin ithe iUnited iStates.

1. iA iwithholding itax itakes ia iset iamount iof imoney iout iof ian iemployee’s ipaycheck iand ipays iit ito ithe igovernment.

2. The imoney itaken iis ia icredit iagainst ithe iemployee’s iannual iincome itax.

3. If itoo imuch imoney iis iwithheld, ian iemployee iwill ireceive ia itax irefund; iif inot ienough iis iwithheld, ian iemployee iwill ihave ian iadditional itax ibill.

Withholding itaxes iis ia iway ifor ithe iU.S. igovernment ito itax iat ithe isource iof iincome, irather ithan itrying ito icollect iincome itax iafter iwages iare iearned. iThere iare itwo idifferent itypes iof iwithholding itaxes iemployed iby ithe iInternal iRevenue iService i(IRS) ito iensure ithat iproper itax iis iwithheld iin idifferent isituations.

U.S. iresident iwithholding itax

The ifirst iand imore icommonly idiscussed iwithholding itax iis ithe ione ion iU.S. iresidents' ipersonal iincome ithat imust ibe icollected iby ievery iemployer iin ithe iUnited iStates.

Nonresident iwithholding itax

The iother iform iof iwithholding itax iis ilevied iagainst inonresident ialiens ito iensure ithat iproper itaxes iare imade ion iincome isources ifrom iwithin ithe iUnited iStates. iA inonresident ialien iis isomeone iwho iis iforeign-born iand ihas inot ipassed ithe igreen icard itest ior ia isubstantial ipresence itest. iAll inonresident ialiens imust ifile iForm i1040NR iif ithey iare iengaged iin ia itrade ior ibusiness iin ithe iUnited iStates iduring ithe iyear. iIf iyou iare ia inonresident ialien, ithere iare istandard iIRS ideduction iand iexemption itables ito ihelp iyou ifigure iout iwhen iyou ishould ibe ipaying iU.S. itaxes iand iwhich ideductions iyou imay ibe iable ito iclaim.

Most ipeople idon't igive ia isecond ithought ito itoday's itax iwithholding isystem, ibut itaxes ihaven't ialways ibeen iwithheld iat ithe isource, iand ithere iare icompelling icriticisms iof ithe iwithholding isystem. iIn igeneral, itax iwithholding iis igood ifor ithe igovernment iand ibad ifor itaxpayers.

a. Most ifull-time iemployees iin iAmerica iare ifamiliar iwith ithe itax iwithholding isystem i- iwhere ia iportion iof ia ipay iperiod's igross iincome ihas ibeen ideducted ifor itax ipurposes.

b. The ibenefits iof ithis iprocess iinclude iensuring iworkers ihave ienough imoney ito ipay itheir itaxes, imaking iit iharder ito ievade itaxes, iand ia isteady iflow iof iincome ifor ithe igovernment.

c. Drawbacks iinclude iover-paying itaxes ithat icreate iopportunity icosts ifor iworkers, ias iwell ias iencouraging ia idisconnect ior iapathy ibetween iemployment iincome iand itaxes ithat ican ifuel iunchecked igovernment ispending.

Benefits iof ithe iTax iWithholding iSystem

The itax iwithholding isystem iwas iimplemented ito ihelp ithe igovernment iraise imoney ito ifinance ivarious iwars iand ito imake iit ieasier ifor ithe igovernment ito iincrease itaxes iwithout icitizens iprotesting. iHere iare ia ifew iof ithe ibenefits iof icollecting itaxes iat ithe isource i- iand inotice ithat imost iof ithese ibenefits igo ito ithe igovernment, inot ithe itaxpayers.