Adjustment to Income

Taxpayers can subtract certain expenses, payments, contributions, fees, etc. from their total income. The adjustments, subtracted from total income on Form 1040, establish the adjusted gross income (AGI).

Some items in the Adjustments to Income section are out of scope. This lesson will cover all in-scope topics. Refer to the Volunteer Resource Guide, Tab B, Starting a Return and Filing Status, or go to irs.gov to view Form 1040.

How to determine if the taxpayer has adjustments to income?

During the tax year did the taxpayer or spouse:

• Pay qualified educator expenses?

• Receive income from self-employment?

• Have self-employed health insurance?

• Pay a penalty for early withdrawal of savings?

• Pay alimony?

• Make charitable contributions?

• Make contributions to a traditional IRA?

• Make a contribution to a health savings account?

• Pay student loan interest?

• Receive income from jury duty that was turned over to an employer?

• Have a Form W-2 Box 12 code H contribution to Sec 501(c)(18)(D) pension plan?

There are other adjustments to income, such as self-employed SEP, SIMPLE, and qualified plans and domestic production activities deductions. These are beyond the scope of the VITA/TCE programs. If you believe you could benefit from one of these other adjustments, you are encouraged to consult a professional tax preparer.

How do I handle educator expenses?

Who is eligible?

Eligible educators can deduct up to $250 of qualified expenses paid during the tax year. If the taxpayer and spouse are both eligible educators, they can deduct up to $500, but neither can deduct more than their own expenses up to $250. The deduction amount is indexed for inflation, so future maximum deduction amounts may be higher.

If the taxpayer or spouse is an educator, relevant questions are:

• Are you or your spouse a teacher, instructor, counselor, principal, or aide in a school? (Cannot be a

home school)

• What grade or grades do you teach? (Must be K-12)

• Were you employed for at least 900 hours during the school year? (Required minimum)

What expenses qualify?

If the taxpayer or spouse is an eligible educator, their qualified expenses are considered. Taxpayers must have receipts for verification if they get audited.

Expenses that qualify include books, supplies, equipment (including computer equipment, software, and services), and other materials used in the classroom. The educator’s own professional development expenses related to the curriculum in which the educator provides instruction are also included. Qualified expenses don’t include expenses for home schooling or for nonathletic supplies for courses in health or physical education.

What other rules apply?

If the taxpayer or spouse received reimbursement, that would reduce the amount of their educator expenses. For example:

• Did you receive reimbursement that is not listed as income on Form W-2?

• Did you redeem U.S. Series EE or I Savings Bonds where the interest would be tax-free, such as

redeeming savings bonds to pay educational expenses?

• Did you receive a nontaxable distribution from a qualified tuition program (QTP) or a distribution of

nontaxable earnings from a Coverdell education savings account (ESA)?

Educator expenses are reduced by any of these applicable reimbursements.

How do I report this?

Educator expenses are reported in the adjustments section of Form 1040, Schedule 1. Don’t forget to reduce the total educator expenses by any reimbursements, nontaxable savings bond interest, nontaxable distribution from a QTP, or nontaxable distribution of earnings from an ESA.

How do I handle self-employed health insurance deduction?

Self-employed taxpayers who reported a net profit on Schedule C for the year may be able to deduct the cost of their health insurance paid as a deduction from their gross income. The insurance plan must be established under the trade or business and the deduction cannot be more than the earned income from that trade or business. When filing Schedule C, the health insurance policy can be either in the taxpayer’s name, the spouse’s name (if Married Filing Jointly), or in the name of the business.

Medicare premiums voluntarily paid to obtain insurance in the taxpayer’s name that is similar to qualifying private health insurance can be used to figure the deduction. The spouse’s Medicare premiums qualify for the deduction when Married Filing Jointly even though paid from the spouse’s benefits. Include health, dental, vision, supplemental, limited coverage, and long-term care (LTC) premiums. LTC is limited to the deduction cap for Schedule A, based on age.

Self-employed taxpayers cannot deduct payments for medical insurance for any month in which they were eligible to participate in a health plan subsidized by their employer, a spouse’s employer, or an employer of the taxpayer’s dependent or child under age 27 at the end of the tax year. Taxpayers cannot deduct payments for a qualified long-term care insurance contract for any month in which they were eligible to participate in an employer-subsidized long-term care insurance plan.

Whose health coverage qualifies?

For this purpose, health coverage can be for the taxpayer, spouse, dependents, or the taxpayer’s child under the age of 27 even though the child is not the taxpayer’s dependent. A child includes a son, daughter, stepchild, adopted child, or foster child.

What is the limit on the self-employed health insurance deduction?

The self-employed health insurance deduction is limited to the net self-employment profit shown on the return reduced by the deduction for one-half of the self-employment tax.

What if the insurance was purchased through the Marketplace?

Self-employed taxpayers who purchased their coverage from the Marketplace and are eligible for the Premium Tax Credit are out of scope for the VITA/TCE programs.

How do I handle penalties on early withdrawal of savings?

Taxpayers can adjust their gross income to deduct penalties they paid for withdrawing funds from a deferred interest account before maturity. Ask if the taxpayer and/or spouse made any early withdrawals during the tax year. If so, ask to see Form 1099-INT, Interest Income, or Form 1099-OID, Original Issue Discount, documenting the penalty. The early withdrawal penalty deduction is reported on Form 1040, Schedule 1

How do I handle alimony paid?

Pre-2019 Divorces

Alimony is a payment to a spouse or former spouse under a divorce or legal separation instrument. The payments do not have to be made directly to the ex-spouse. For example, payments made on behalf of the ex-spouse for expenses specified in the instrument, such as medical bills, housing costs, and other expenses can qualify as alimony. Alimony does not include child support or voluntary payments outside the instrument. The person paying alimony can subtract alimony payments as an adjustment to income; the person receiving alimony must treat it as income. A summary of the alimony requirements can be found in Tab E, Adjustments, in the Volunteer Resource Guide.

Did the taxpayer paid alimony under a divorce or separation instrument?

If so, you need the exact amount, as well as the Social Security number of the recipient, because the recipient must report the payment to the IRS as income and the two amounts must agree. The date of the divorce, or a reasonable estimate, is also needed to complete Schedule 1.

For additional information on alimony, refer to the Alimony chapter in Publication 17 and Publication 504,

Divorced or Separated Individuals.

Post-2018 Divorces

Alimony or separate maintenance payments made under a divorce or separation agreement (1) executed after 2018, or (2) executed before 2019, but later modified if the modification expressly states the repeal of the deduction for alimony payments applies to the modification, are no longer deductible. Alimony and separate maintenance payments received under such an agreement are not included in the gross income of the recipient.

How do I handle IRA contributions?

Individual Retirement Arrangements (IRAs) are personal savings plans that offer tax advantages to set aside money for retirement. This section discusses “traditional” IRAs. A traditional IRA is any IRA that is not a Roth or SIMPLE IRA. See the Individual Retirement Arrangements (IRAs) chapter in Publication 17, and Publication 590-A, Individual Retirement Arrangements, for more information on all types of IRAs.

Some of the features of a traditional IRA are:

• Taxpayers may be able to deduct some or all of their contributions to the IRA (depending on circumstances).

• Generally, amounts in an IRA, including earnings and gains, are not taxed until distributed.

• Contributions may be eligible for the retirement savings contributions credit.

Although contributions to a Roth IRA cannot be deducted, the taxpayer may be eligible for the retirement savings contributions credit, discussed in the lesson on Miscellaneous Credits

What are the eligibility requirements for an IRA contribution?

The taxpayer, and the taxpayer’s spouse if applicable, must meet these eligibility requirements in order to make an IRA contribution:

• Types of IRAs: Verify the types of IRAs to which the taxpayer and spouse contributed. Only contributions

to traditional IRAs are deductible.

• Age limit: Under the SECURE Act of 2019, there is no age limit for either traditional or Roth IRA contributions effective for tax years beginning after December 31, 2019.

• Compensation: Individuals must have taxable compensation (i.e., wages, self-employment income, commissions, taxable alimony, or taxable scholarships or fellowships, as shown in Box 1 of Form W-2).

• Time limits: Contributions must be made by the due date for filing the return, not including extensions.

The taxpayer and spouse must have made the contribution(s) (or will make them) by the due date of the return.

How much can a taxpayer deduct for an IRA contribution?

Generally, you can deduct the lesser of:

• The contributions to your traditional IRA for the year, or

• The general limit reduced for Roth IRA contributions made for the same tax year

What is the compensation requirement?

Compensation is generally the income a taxpayer has earned from working; it also includes taxable alimony, and other forms of earned income. (See Publication 17 for more information on compensation.) Taxpayers cannot make IRA contributions that are greater than their compensation for the year

If taxpayers file a joint return, and one spouse’s compensation is less than the other spouse’s compensation, the most that can be contributed for that spouse is the lesser of:

• The general limits, or

• The total compensation includible in the gross income of both spouses for the year, reduced by:

– Traditional IRA contributions for the spouse with the greater compensation

– Any contribution for the year to a Roth IRA for the spouse with the greater compensation

In other words, as long as they file a joint return, married taxpayers’ combined IRA contributions cannot exceed their combined compensation, and neither spouse can contribute more than the general IRA limit to their own IRA.

Beginning in 2019, taxpayers can elect to increase their compensation for difficulty of care payments that are excluded from gross income for the purpose of nondeductible IRA contributions.

Are there special rules for certain military personnel?

Current or former members of the Armed Forces may qualify for additional retirement benefits. Under the Heroes Earned Retirement Opportunities (HERO) Act, taxpayers can count tax-free combat pay as compensation when determining whether they qualify to contribute to either a Roth or traditional IRA. Before this change, members of the Armed Forces whose earnings came entirely from tax-free combat pay were generally barred from using IRAs to save for retirement.

When can IRA contributions be deducted?

Deductions can be taken for contributions to traditional IRAs for returns that are in scope. The taxpayer’s deduction for IRA contributions may be “phased out” (i.e., reduced or eliminated) depending on their income, filing status, and whether the taxpayer is covered by a retirement plan at work. The difference between the permitted contributions and the IRA deduction, if any, is the taxpayer’s nondeductible contribution. Form 8606, Nondeductible IRAs, must be completed for any nondeductible traditional IRA contributions.

If taxpayers do not report nondeductible contributions, all of the contributions to a traditional IRA will be treated as having been deducted. This means all distributions will be taxed when withdrawn unless the taxpayer can show, with satisfactory evidence, that nondeductible contributions were made.

Form 8606 requires basis information in IRAs from prior years and can be complex. If Form 8606 is required, refer the taxpayer to a professional tax preparer.

How do I determine the deduction amount?

The factors that affect whether traditional IRA contributions are deductible include:

• Whether the taxpayer (or spouse, if filing a joint return) is covered by a retirement plan at work.

• The taxpayer’s Modified Adjusted Gross Income (MAGI) before taking the deduction. If the taxpayer or spouse is covered by a retirement plan, the deduction amount will be reduced or eliminated if the MAGI on the tax return is above a certain limit.

Retirement coverage at work

If the taxpayer and/or spouse were covered by a retirement plan at work at any time during the tax year, their deduction may be limited. Employees covered by a retirement plan will have Box 13 on Form W-2 checked.

Filing status and income

If the taxpayer or spouse was covered by an employer retirement plan, they may not be able to deduct the full amount. Notice that the income limitation amount may be different for each spouse on a joint return, but that the MAGI computation is the same. This is because if one spouse is covered by a retirement plan but the other is not, the noncovered spouse will have a higher income limit before their IRA deduction is phased out.

If the MAGI is greater than the income limits, the deduction cannot be taken. If this is the case, explain to the taxpayers and answer any questions they may have about why the deduction cannot be taken. The contribution may still be made, it is just not deductible.

Enter the total contributions to traditional IRAs that were made (or will be made) for each spouse (on a joint return) by the due date of the return.

How do I report the IRA deduction?

Report the deduction in the adjustments section of Form 1040, Schedule 1.

What if the taxpayer has an excess IRA contribution?

An excess IRA contribution is an amount contributed to a traditional or Roth IRA that is more than the lesser of:

• The taxable compensation for the year, or

• General limit amount

The taxpayer may not know that a contribution qualifies as “excess” until the tax return is completed. When this situation is identified, the excess amount, with any earnings on that amount, must be withdrawn by the due date of the return (including extensions). If the excess amount is not withdrawn by the due date of the return, including extensions, the taxpayer will be subject to an additional 6% tax on this amount.

Taxpayers subject to the additional 6% tax should refer to a professional tax preparer

The withdrawn excess contribution is not included in the taxpayer’s gross income before the tax return is due if both of the following conditions are met:

• No deduction was allowed for the excess contribution

• All interest or other income earned on the excess contribution is withdrawn

If taxpayers timely filed the tax return without withdrawing a contribution that they made during the tax year, they can still have the contribution returned to them within 6 months of the due date of the tax return, excluding extensions.

Taxpayers must include in gross income the interest or other income that was earned on the excess contribution. Taxpayers must report it on their return for the year in which the excess contribution was made.

The withdrawal of interest or other income may be subject to an additional 10% tax on early distributions.

Form 1099-R

Taxpayers will receive Form 1099-R indicating the amount of the withdrawal. If the excess contribution was made in a previous tax year, the form will indicate the year in which the earnings are taxable.

How do I handle Health Savings Accounts?

What is an HSA?

An HSA is a tax-exempt trust or custodial account that a taxpayer sets up with a qualified HSA trustee. Distributions from an HSA are nontaxable if the funds are used for qualified medical expenses. A taxpayer must be an eligible individual to qualify to contribute to an HSA.

Individuals Who Qualify for an HSA

To be an eligible individual and qualify for an HSA, the taxpayer must meet the following requirements:

• Be covered by a high-deductible health plan (HDHP) on the first day of the month

• Not be covered by other health insurance (see Publication 969 for exceptions)

• Not be enrolled in Medicare (the individual can be HSA-eligible for the months before being covered by Medicare)

• Not be eligible to be claimed as a dependent on someone else’s tax return (see Caution)

If another taxpayer is entitled to claim the individual as a dependent, the individual cannot claim a deduction

for an HSA contribution. This is true even if the other person does not actually claim the dependent.

Rules for Married Individuals

In the case of married individuals, each spouse who is an eligible individual who wants to have an HSA must open a separate HSA. Married couples cannot have a joint HSA, even if they are covered by the same HDHP; however, distributions can be used to cover the qualified expenses of the other spouse.

In the event of the death of one of the married individuals, the HSA will be treated as the surviving spouse’s HSA if the spouse is the designated beneficiary of the HSA.

Contributions to HSA

Any eligible individual can contribute to an HSA. For an employee’s HSA, the employee, employer, or both may contribute to the employee’s HSA in the same year. For an HSA established by a self-employed (or unemployed) individual, the individual can contribute. Family members or any other person may also contribute on behalf of an eligible individual. Contributions to an HSA must be made in cash. Contributions of stock or property are not allowed.

Amounts contributed to an HSA, except for employer contributions and qualified HSA funding distributions from IRAs, can be used as an adjustment to income for the account owner.

Employer Contributions

Employer contributions (including an employee’s contribution through a cafeteria plan) are allowed to be made to an employee’s HSA. Generally, employer contributions are excluded from an employee’s income. Employer contributions are reported on Form W-2, Box 12 using code W. Taxpayers must reduce the amount they, or any other person, can contribute to their HSA by the amount of any contributions made by the taxpayer’s employer that are excludable from income. This includes amounts contributed to the taxpayer’s account by the employer through a cafeteria plan. For example, if the employer contributed $1,000 to a taxpayer’s HSA who had a self-only HDHP, the remaining contribution limit would be reduced by that $1,000. Refer to the Volunteer Resource Guide,Tab E, Adjustments, for current year contribution limits.

HSA Limits on Contributions

The amount the taxpayer or another other person can contribute to the taxpayer’s HSA depends on the type of HDHP coverage (individual or family) the taxpayer has, the taxpayer’s age, the date the taxpayer became an eligible individual, and the date the taxpayer ceases to be an eligible individual. Eligible individuals who are 55 or older by the end of the tax year can increase their contribution limit up to $1,000 a year. This extra amount is the catch-up contribution allowed for an HSA. Refer to HSA contribution limits in the Volunteer Resource Guide, Tab E, Adjustments.

Rules for Married People

The rules for married people apply only if both spouses are eligible individuals. If either spouse has family HDHP coverage, the family contribution limit applies; both spouses are treated as having family HDHP coverage.

If both spouses are 55 or older and not enrolled in Medicare:

• Each spouse is entitled to increase his or her contribution limit with an additional contribution.

• Their maximum total contributions under family HDHP coverage would include a catch-up contribution for

each spouse.

• The contribution limit is divided between the spouses by agreement. If there is no agreement, the

contribution limit is split equally between the spouses.

• Any additional contribution for age 55 or over must be made by each spouse to his or her own HSA.

Distributions from an HSA

Distributions for Qualified Medical Expenses

Generally, taxpayers will pay medical expenses during the year without being reimbursed by the HDHP until the plan’s annual deductible is reached. When the taxpayer pays these medical expenses that are not reimbursed by the HDHP, the taxpayer can request a distribution from the HSA trustee. The taxpayer can receive tax-free distributions from an HSA to pay or be reimbursed for qualified medical expenses incurred in the current or prior year, but after the taxpayer establishes the HSA.

Qualified medical expenses are expenses that generally would qualify for the medical and dental expenses deduction. Examples include unreimbursed expenses for doctors, dentists, and hospitals. The Coronavirus Aid, Relief, and Economic Security (CARES) Act modifies the rules that apply to various tax-advantaged accounts (HSAs, Archer MSAs, Health FSAs, and HRAs) so that additional items are “qualified medical expenses” that may be reimbursed from those accounts. Specifically, the cost of menstrual care products is now reimbursable. These products are defined as tampons, pads, liners, cups, sponges or other similar products. In addition, over-the-counter products and medications are now reimbursable without a prescription. The new rules apply to amounts paid after Dec. 31, 2019. Health insurance premiums are not included as qualified medical expenses except for Medicare premiums.

For recordkeeping requirements on HSA distributions see Publication 969, Distributions from an HSA.

Taxpayers are not required to take annual distributions from their HSA. However, taxpayers who have taken HSA distributions will receive Form 1099-SA, Distributions from an HSA, Archer MSA, or Medicare Advantage MSA, from their HSA trustee and must provide it before the return can be completed.

Form 8889, Health Savings Accounts (HSA)

A taxpayer must complete Form 8889 with Form 1040 if the taxpayer (or spouse if filing a joint return) had any activity in an HSA. This is true even if only the taxpayer’s employer or the spouse’s employer made contributions to the HSA.

Taxpayers who are filing jointly and who each have separate HSAs will each complete a separate Form 8889. Married taxpayers cannot have a joint HSA.

If your HDHP coverage is “self-only” or “family,” and check the corresponding box on Form 8889, click to view Form 8889.

Form 8889, Part I

Form 8889, Part 1, is used to report all HSA contributions and to compute the allowable HSA deduction. This includes contributions made by the filing deadline that are designated for the tax year. Contributions made by an employer are also shown in Part I, but are not included in the deductible amount.

An HSA may receive contributions from an eligible individual or any other person, including an employer or a family member, on behalf of an eligible individual.

Form 8889, Part II

Form 8889, Part II, is used by taxpayers to report distributions from an HSA. Taxpayers receive tax-free distributions from an HSA to pay or be reimbursed for qualified medical expenses. The taxpayer will have to tell you what types of expenses were paid or reimbursed with the distribution.

Form 1099-SA reports distributions to a taxpayer. Box 5 will indicate whether the distribution is from an HSA, Archer MSA, or a Medicare Advantage MSA. The code in Form 1099-SA, Box 3, identifies the distribution the taxpayer received. Code 1 is a normal distribution. Refer to Form 1099-SA for an explanation of the other codes.

If distributions are not offset with qualified medical expenses, the amount withdrawn will be included in income and reported on Form 1040. HSA distributions included in income are subject to an additional 20% tax unless the account beneficiary:

• Dies

• Becomes disabled (see Form 8889 instructions)

• Turns age 65

Form 8889, Part III

Form 8889, Part III, is out of scope for the VITA and TCE programs

How do I handle student loan interest?

The student loan interest deduction is generally the smaller of $2,500 or the interest payments paid that year on a qualified student loan. This amount is gradually reduced (phased out) or eliminated based on the taxpayer’s filing status and MAGI.

What type of interest qualifies?

Generally, student loan interest is paid during the year on a loan for qualified higher education expenses. The loan must meet all three of these conditions:

• It was for the taxpayer, the taxpayer’s spouse, or a person who was the taxpayer’s dependent when the loan was obtained

• The qualified higher education expenses were paid within a reasonable period of time before or after obtaining the loan

• It was for an eligible student

Interest does not qualify if the loan was from a related person, a qualified employer plan, or if the taxpayer is not legally liable for the loan.

What are the exceptions?

For purposes of the student loan interest deduction, the following are exceptions to the general rules for dependents:

• An individual can be your dependent even if you are the dependent of another taxpayer

• An individual can be your dependent even if the individual files a joint return with a spouse

• An individual can be your dependent even if the individual had gross income for the year that was equal to or more than the threshold amount for the year (see the Volunteer Resource Guide, Tab E, Adjustments, for the current year amount)

Who is eligible for the deduction?

Generally, a taxpayer can claim the deduction if all the following are true:

• The taxpayer is not using the Married Filing Separately filing status

• The taxpayer will not be claimed as a dependent on someone else’s return

• The taxpayer is legally obligated to pay interest on a qualified student loan

• The taxpayer paid interest on a qualified student loan

What are qualified higher education expenses?

Qualified expenses include: tuition and fees; room and board; books, supplies and equipment; and other necessary expenses (such as transportation).

Qualified expenses must be reduced by certain other educational benefits. Ask the taxpayer if the expenses were offset by any of the following:

• Employer provided educational assistance benefits

• Tax-free distributions from a Coverdell ESA or from a qualified tuition program

• U.S. savings bond interest excluded from income because it is used to pay qualified higher education expenses

• Certain scholarships and fellowships

• Veteran’s educational assistance benefits

• Any other nontaxable payments (other than gifts, bequests, or inheritances) received for educational expenses

No double benefit allowed

Taxpayers cannot deduct as interest on a student loan any amount that is an allowable deduction under any other provision of the tax law (e.g., as business interest).

A taxpayer cannot deduct as interest on a student loan any amount paid from a distribution of earnings made from a qualified tuition program (QTP) after 2018 to the extent the earnings are treated as tax free because they were used to pay student loan interest.

What is an eligible educational institution?

An eligible educational institution is generally any accredited public, nonprofit, or private post-secondary institution eligible to participate in the student aid programs administered by the Department of Education. It includes virtually all accredited, public, nonprofit, and privately owned profit-making post-secondary institutions. If the taxpayers do not know if an educational institution is an eligible institution, they should contact the school. A searchable database of all accredited schools is available on the U.S. Department of Education website.

Who is an eligible student?

An eligible student is someone enrolled at least half-time in a program leading to a degree, certificate, or other recognized educational credential. The standard for what is half the normal full-time work load is determined by each eligible educational institution.

Where can I get the information?

If the taxpayer paid $600 or more in interest to a single lender, the taxpayer should receive Form 1098-E, Student Loan Interest Statement, or another statement from the lender showing the amount of interest paid. This information will assist you in completing the student loan interest deduction.

The taxpayer should keep documentation of all qualified student loan interest paid during the tax year. See Publication 970, Tax Benefits for Education, for more information on the Student Loan Interest Deduction.

Is pay for jury duty an adjustment to income?

As discussed earlier, jury duty pay received by taxpayers is included in Other income on Form 1040, Schedule 1. Some employees receive their regular wages from their employers while they are serving on a jury instead of working at their jobs.

Often, employees must turn their jury duty pay over to their employers. This may be claimed as an adjustment to income.

Is a charitable contribution adjustment allowed?

Taxpayers may deduct up to $300 of cash contributions to charitable organizations per return when they do not itemize their deductions. This provision applies to the 2020 tax year only. Refer to the Itemized Deductions lesson for the definition of a qualified charitable organization.

How do I determine Adjusted Gross Income?

The taxpayer’s total Adjusted Gross Income (AGI) is the amount that is used to compute some limitations, such as the medical and dental deduction on Schedule A and the credit for child and dependent care expenses. To find the taxpayer’s AGI:

1. Add the Income section. This is the taxpayer’s total income.

2. Add the Adjustments to Income section. These are the total Adjustments.

3. Subtract the Schedule 1 adjustments from the total income. This is the AGI.