This time of year media outlets are full of tax tips and ideas for “last minute” tax savings. The best tax professionals will tell you that to be effective tax planning needs to be proactive, not reactive. Tax planning needs to happen all year long, not just during the last few weeks of the year. But no matter the timing, all of this year-end tax advice hinges on the idea that taxpayers understand the “why” behind the tips. And the truth is, many don’t. Consequently, the single best year-end tax tip is to understand the mechanics of Form 1040. When you understand Form 1040 not only can you make smart tax moves throughout the year, you can understand why they are smart tax moves.
Adjusted Gross Income (or AGI)
Possibly the most important line on Form 1040 the line that reports AGI. For 2021 AGI is reported on Form 1040, Line 11. AGI includes all taxable items of income including those taxed at preferential rates (e.g., capital gains). AGI is important because many tax benefits are phased out based on AGI amounts. For example, the amount of the three rounds of Economic Impact Payments (stimulus checks) were reduced, eventually to zero, based on AGI. AGI is also what lenders (especially mortgage lenders) look at when evaluating loan applications. It’s essential for taxpayers to understand what their AGI is and equally important to understand items that can adjust that number up or down.
Other Income and Above-the-Line Adjustments
Schedule 1 of Form 1040 is where adjustments to AGI are made. Part I of Schedule 1 includes a list of the most common types of “other income” that can increase a taxpayer’s AGI. These items flow to Line 8 of Form 1040.
Certain above-the-line adjustments, however, decrease AGI. Technically speaking, these adjustments are not deductions—their effect on the amount of tax owed is the same, but their effect on AGI is not. If reducing your AGI will put you under the threshold, for say, repaying the advanced premium tax credit (the subsidized part of marketplace healthcare coverage) then recognizing when you may have items that will adjust your AGI is essential. Part II of Form 1040, Schedule 1 includes a list of income adjustments. Some of the most common above-the-line adjustments to income are for educator expenses, student loan interest, and the deductible part of self-employment (SE) tax (a self-employed person’s contributions to Medicare and Social Security, more on that later).
Taxable Income
Often taxpayers concerned about their “tax bracket” (or marginal tax rate, more on that below) look at their AGI and panic. Panic prevention is why it’s important to understand the difference between AGI and taxable income. Taxable income is the amount of income on which tax is paid. At its most basic it is AGI minus either the standard deduction for your filing status (single, married filing jointly, married filing separately, or head of household) or your itemized deductions. And that’s why it’s also important to understand the difference between using the standard deduction or itemizing deductions.
Standard v. Itemized Deductions
Many year-end tax tips are predicated on being able to use Form 1040, Schedule A to itemize deductions. Since the Tax Cuts & Jobs Act roughly doubled the standard deduction for all filing statuses through the end of 2025, the number of people who benefit from itemizing their deductions has decreased dramatically. It is not a deep financial failing to take the standard deduction if that is where you realize the higher tax benefits. For tax year 2021 the standard deductions are as follows:
- Single & Married Filing Separately – $12,550
- Married Filing Jointly – $25,100
- Head of Household – $18,800
Married taxpayers get an additional $1350 for each person who is age 65 and/or blind. Single taxpayers and those who file head of household get an additional $1700 for being age 65 and/or blind. Even using the base deductions married taxpayers who file a joint return would have to have more than $25,100 in itemized deductions to get any tax benefit. That’s a lot of deductions.
Year-end tax tips often focus on a few above-the-line deductions and maximizing itemized deductions but they also often omit the fine print. For example, qualifying medical expenses can increase itemized deductions, but the first 7.5% of your deductions based on your AGI (with some additional adjustments) are not deductible. The higher the income, the higher the threshold above which medical expenses become deductible. Often, medical expenses have to border on the catastrophic before upper middle income taxpayers can deduct them. And, of course, as of right now the itemized deduction for state and local tax (or SALT) is capped at $10,000.
Charitable deductions can be itemized but are typically capped at a percentage of AGI. Some exceptions have been made for tax years 2020 and 2021. In 2021 taxpayers who do not itemize can take a small deduction for up to $300 in cash contributions to qualifying charities (or $600 for joint filers). And finally, the Tax Cuts & Jobs Act also eliminated the itemized deductions for unreimbursed employee expenses and other “miscellaneous itemized deductions” through tax year 2025. In other words, it doesn’t hurt to review lists of tax tips, but it is equally important to be aware that not everyone will be able to benefit from them.
Deduction or Tax Credit
Tax tips are often positioned as “most frequently overlooked deductions.” Deductions, again assuming it’s more beneficial to itemize them than to take the standard deduction, reduce your taxable income. Effectively you are spending a dollar to save pennies. For example, taxpayers in the 12% bracket are spending a dollar (on medical, on charity, on state and local taxes) to save twelve cents in taxes. That’s not good math unless you were planning on spending that money anyway. Spend the money you would normally spend and take every deduction that is legally available to you. But don’t spend money you wouldn’t otherwise consider spending just to get a tax deduction.
Credits, on the other hand, are a dollar for dollar reduction in tax. Often, to receive a credit a taxpayer must have tax to which it can be applied. In other words, if the taxpayer’s income is so low that no tax is owed, they do not receive the benefit of the credit. Some unused credits carry forward, others do not. Whether or not they carry forward, tax credits that can only be applied against tax due are called “non-refundable” credits. Other credits are refundable. Even if a taxpayer does not owe any tax they can receive the credit. The Earned Income Tax Credit, the Child Tax Credit, the American Opportunity Credit, and (for 2021 only as of this writing) the Child and Dependent Care Credit are examples of refundable credits. Taxpayers who use a professional to prepare their returns should be aware that there are heightened due diligence requirements for professionals claiming refundable credits for their clients. Tax professionals are expected to ask a lot of questions (and document the questions and the answers) for taxpayers claiming these credits. The increased due diligence can also increase the price of return preparation.
Marginal & Effective Tax Rates
Your marginal tax rate is what is often called your “tax bracket.” Current tax brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Many taxpayers believe that moving to a new marginal rate means that all of their income is taxed at that rate. That is not how it works. Your tax bracket applies progressively to your taxable (not your gross) income. At its simplest this means that, as explained above, you take your AGI and subtract your itemized or standard deduction to arrive at your taxable income. The marginal rates are then applied to this taxable income in order: the first $9,950 of income ($19,900 for joint filers) is taxed at 10%; taxable income of $9,951 up to $40,525 is taxed at 12%; the bit from $40,526 to $86,376 is taxed at 22% and so on.
Your effective tax rate is the rate you actually pay on your income. If you don’t have much income in the 24% bracket, for example, it’s possible that your effective rate could be 22%. It could be lower than that because some income is taxed as “ordinary” while other income receives lower “capital gains” rates. Capital gains rates are the reason why Warren Buffet says he pays a lower tax rate than his secretary. Most of his income comes from his money making him more money. That kind of income is taxed at capital gains rates. Earned income, however, is taxed as ordinary income and is subject to the marginal rates as described above.
Income Tax and Self-Employment Tax
It is possible for a low income self-employed taxpayer to pay no income tax but still have a balance due on their Form 1040. Often for self-employed individuals SE tax (Social Security and Medicare) is a larger part of the balance due on Form 1040 than income tax. Why? First because self-employed taxpayers must pay both the employer and the employee parts of SE tax. Employees getting a Form W2 have their employee contributions withheld from their paychecks and their employer pays the other half. Second, because many self-employed taxpayers don’t pay attention to their quarterly profits and make the necessary estimated payments. For example, let’s take a taxpayer who makes $5,000 per quarter in profit (gross income minus expenses). SE tax is roughly 15% or $750 per quarter for this taxpayer. That’s $3,000 in SE tax for the year. Assume the taxpayer has no other income and takes the standard deduction. The taxpayer is allowed to reduce their $20,000 AGI by the employer part of the SE tax ($20,000 minus $1,500 is $18,500 in AGI). Subtracting the standard deduction of $12,550 leaves the taxpayer with $5,950 in taxable income. The tax on that would be $595. That’s less than one quarter’s worth of SE tax! This taxpayer’s balance due, assuming no estimated payments were made, would be $3,595! Yikes. The example illustrates why self-employed taxpayers (or those with side hustles) who don’t feel like they are earning much money should pay attention to their quarterly profits and plan at least for the effect of SE tax on their Form 1040 results by making quarterly estimated payments as appropriate. Income tax should also be factored into the quarterly estimates as profit increases or if the taxpayer or their household has other income.
Conclusion
This article provides a basic overview of the mechanics of Form 1040. The Internal Revenue Code is a complex mass of moving parts. It’s similar to the software that runs the IRS. It’s big and many pieces are interrelated, but others aren’t or the relationships aren’t always clear. This summary is not a substitute for the advice of a qualified, competent tax professional but it may help you to understand the “why” of the various tax tips being offered this time of year and help you to understand whether or not they may apply to your situation. Finally, it may help you to understand the language spoken by your tax professional which will help you understand the information on your tax return.