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Advisor Insights

Avoid the Income Funnel Trap

To reduce income tax, do what you can to limit the flow of items into the top lines of your tax return.

Once a fish swims into a funnel-type fish trap, he can just about never swim out again. So it is with our income tax system. Once "income" goes into the wide mouth of the trap, avoiding tax is like swimming upstream. To minimize taxes, you need to concentrate on "above-the-line" deductions that reduce adjusted gross income, and (better yet) on getting the types of income that avoid the funnel altogether.

Here's how the federal income tax system works. "Gross income" is swept into the wide mouth of the trap, bringing you to line 22 of your Form 1040 ("Total income"). Then you get to reduce this number by taking certain highly favored deductions, to arrive at adjusted gross income (line 37). Finally, you take out some not-quite-as-good but still pretty good deductions to arrive at taxable income (line 43). One of our five different personal income taxes is then imposed on this number.