Avoiding the Retiree Tax Attack

Income taxes are rising on those in or planning for retirement. Remember, the true value of your nest egg is its after-tax value. Politicians at all levels know that in-come and wealth are concentrated among those 55 and older, so those people are the focus of tax increases.

The retiree tax attack tends to be delivered in hidden, stealthy, or complicated taxes instead of straightforward tax increases. Examples are the surtax on Medicare premiums, the new investment income tax under Obamacare, and taxes on Social Security benefits, to name the most prominent drains on your wealth. Your taxes also can be increased by the phaseout of personal exemptions and reduction in itemized expenses.

You don’t have to sit back and accept the attack on retiree wealth and income.

Each of these taxes has separate rules and exceptions. But there’s a common thread that can help minimize the taxes as a group, with some modifications for each of the taxes.

The key to defending against most of the retiree tax attack is to reduce adjusted gross income.

When you look at the traditional Form 1040, adjusted gross income is the last number at the bottom of the first page. First, you add all sources of income to arrive at gross income. Then, you subtract what are called deductions for adjusted gross income. The remainder is your AGI. Reducing AGI is the key to avoiding most of these taxes. Note that itemized expenses such as charitable contributions, medical expenses, and mortgage interest won’t help. They appear later on the tax return.

There are two broad strategies for reducing AGI. One way is to keep gross income low. The other way is to increase deductions for AGI. (But deductions for AGI won’t decrease taxes on Social Security benefits.)

Deductions for AGI aren’t practical for many people age 55 and over, especially those already retired. The deductions include special deductions for teachers, reservists, performing artists, and fee-basis government officials. Also included are health savings account deductions, moving expenses, the deductible part of self-employment taxes, self-employed health insurance premiums, and some self-employed retirement plan contributions. There are a few others that don’t involve much planning, such as alimony payments.

By all means, maximize these deductions to the extent you can. But they don’t offer the most planning opportunities for those in or near retirement.

The best opportunities for reducing the special retiree taxes are to reduce gross income. Progress here reduces taxes on Social Security benefits as well as the other retiree taxes.

Here’s an example of the circular way these taxes can work. When a portion of your Social Security benefits are taxable, that means they’re included in gross income. That increases AGI and potentially triggers a higher Medicare surtax and the other taxes.

These strategies work best for reducing gross income.

Consider tax-exempt bonds. Here’s where things get tricky. Interest from tax-exempt bonds is excluded from gross income for regular income taxes. But it is added to gross income when calculating the Medicare surtax and the taxable portion of Social Security benefits.

But because they are tax-exempt, the bonds usually pay a lower interest rate than comparable taxable bonds or certificates of deposit. Adding the tax-exempt interest to your other income should result in lower gross income than if you owned taxable bonds. So, if you own bonds outside an IRA or other tax-favored account, you’ll likely owe less in retiree taxes by investing in tax-exempt bonds instead of taxable bonds or CDs.

Convert IRAs. When you take distributions from a traditional IRA or 401(k) plan, the distributions are included in gross income and treated as ordinary income. But Roth IRA distributions aren’t included in gross income for purposes of the regular income tax or when computing the retiree taxes. Perhaps even better, with a Roth IRA you aren’t required to take distributions are age 70½. With a regular IRA, those forced distributions trigger higher taxes even when you don’t need the income.

The special taxes on retirees are one reason why converting a traditional retirement account to a Roth IRA can pay off over the long term.

Keep in mind that in the year an IRA is converted, the conversion amount is included in gross income. The converted amount might trigger the Medicare surtax, tax on Social Security benefits, and other retiree taxes discussed here or an increase them. That one-time cost has to be considered in determining whether or not a conversion makes sense.

We’ve discussed many times in past visits the factors to consider before converting an IRA to a Roth IRA. You can find these discussions in the IRA Watch section of the Archive on the members’ web site. Full discussions also are in my books, Personal Finance for Seniors for Dummies and The New Rules of Retirement.

Manage your taxable investments. Tax-wise investment strategies are more important when additional gross income might trigger these extra taxes. You don’t want taxes to dictate investment strategy, but the potential for higher taxes determines whether a particular investment or strategy is best.

It’s a good idea to harvest investment losses. Sell investments that have paper losses to lock in the losses. You can deduct these against capital gains and deduct up to $3,000 of additional losses against other income. Any leftover losses after that are carried forward to future years. If you still like the investment long term, you can buy it back. With stocks, mutual funds, and some other investments you have to wait more than 30 days to repurchase if you want to deduct the loss in the year of the sale.

Be sure your portfolio isn’t generating income you don’t need. High-dividend stocks and mutual funds that distribute most of their gains each year will increase your gross income and perhaps the retiree taxes. Consider switching to more tax-wise investments.

Don’t trade too much in your portfolio. Keep in mind that each capital gain is a potential trigger for increasing the other taxes. Even if you are earning a tax-favored long-term capital gain, it could increase gross income high enough to increase one or more of the retiree taxes.

You also could favor tax-advantaged investments such as master limited partnerships and investment real estate. Again, don’t invest only for the tax benefits. But consider how the tax benefits will avoid the retiree taxes and increase your after-tax returns.

RW April 2013.