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How to Minimize the Most Important Number on Your Tax Return

Published on: Aug 13 2023
estate planning

It’s the most important number on your federal income tax return.

The number I’m referring to is your adjusted gross income (AGI). In your retirement years, AGI is more important than for most other taxpayers.

Before retiring, taxable income probably is the most important line on your return, and many people believe it still is after retiring.

But because of changes over the years, AGI is the key to reducing your retirement income tax burden.

You see, Congress knows retirees have the bulk of the country’s income and wealth.

Few in Congress want to increase tax rates directly, especially on middle class retirees. So, what I call the “Stealth Taxes” were enacted.

When AGI exceeds certain levels, Stealth Taxes are triggered.

Each Stealth Tax is different, but under the Stealth Taxes, tax benefits are reduced or additional taxes and surtaxes are imposed.

For example, there’s the Medicare premium surtax and the inclusion of Social Security benefits in gross income. There used to be provisions to reduce personal and dependent exemptions and itemized expense deductions.

Those were suspended in the 2017 tax law but are scheduled to be reimposed after 2025.

There’s also the 3.8% net investment income tax. Those are the main Stealth Taxes.

When you’re hit with a Stealth Tax, your income tax bill increases though you stay in the same income tax bracket. Some states now use AGI to impose their own Stealth Taxes.

Various government benefit programs also use AGI to determine eligibility. I expect this type of means-testing, in which higher-income individuals pay higher taxes or receive lower benefits, to increase.

Governments at all levels have promised benefits they can’t pay, but they don’t want to enact broad-based tax rate increases.

Your tax planning, especially in retirement, should focus on managing AGI. (The Stealth Taxes really are imposed on modified adjusted gross income (MAGI), not regular AGI. The difference matters in only a few circumstances, which I discuss later.)

Be careful which strategies you use. Some strategies reduce AGI today only to increase it in a few years.

If you’re still working, for example, you can reduce AGI by making the maximum deferral to a 401(k) plan.

But that only defers income and, in fact, increases AGI in the retirement years when you’re most likely to be subject to the Stealth Taxes.

Those still working should focus on strategies that will keep AGI low during the post-career years.

Some of the strategies I discuss below are for the pre-retirement years, others for the retirement years, and some are good for both.

Minimize Your Tax Return’s Most Important Number in Retirement Strategy #1: Take your investment losses.

Anyone who invests in a taxable account is likely to have losses from time to time. Most investors compound the losses by waiting to sell a losing investment until it at least returns to the break-even point.

A better strategy is to sell and realize the capital loss. A realized loss first is deducted against any capital gains for the year keeping them out of your AGI.

Any additional loss is deducted against other income up to $3,000, further reducing AGI. If that doesn’t absorb the entire loss, the additional loss is carried forward to future years to be used in the same way.

Turn that loss into an asset. Bite the bullet and recognize the tax loss so it can be deducted. Plus, you free up the capital to invest in something else that might perform better.

When you like the losing investment for the long term, you can repurchase it after waiting more than 30 days after the sale.

That avoids the “wash sale” rules that would defer the loss deduction.

Minimize Your Tax Return’s Most Important Number in Retirement Strategy #2: Maximize health savings accounts.

A health savings account (HSA) is one of the best shelters available. You can contribute to an HSA when you’re covered by a high-deductible medical insurance plan.

Contributions to the HSA are deductible, or they’re excluded from gross income if the employer makes them on your behalf.

Contributions can be up to $7,300 in 2022 when you have family coverage or $3,650 when you have individual coverage.

An additional catch-up contribution of $1,000 is allowed when you are age 50 or older.

Contributions aren’t allowed once you join Medicare. You can invest the account, and all income and gains compound tax-free.

Finally, when you withdraw money and use it for qualified medical expenses, the distributions are tax-free.

They won’t increase your AGI. HSAs don’t have required minimum distributions. I recommend letting the account accumulate until retirement. Then, when extra income is needed, tax-free distributions from the HSA can be taken.

Minimize Your Tax Return’s Most Important Number in Retirement Strategy #3: Restructure traditional IRAs and 401(k)s.

The Stealth Taxes often are triggered or increased by required minimum distributions (RMDs) that must begin from traditional IRAs and other retirement accounts after age 72.

Since the percentage of the IRA that must be distributed increases each year, RMDs tend to be a real problem for people who are in their late 70s or older.

You can take actions to reduce future RMDs at any time, but the earlier you take action the more effective the strategies will be.

You can simply empty the IRA early. Take distributions and pay the taxes now, then invest the after-tax amount.

That prevents ever-increasing AGI in later years. Or you can convert the traditional IRA to a Roth IRA. That incurs income taxes (and higher AGI) in the year of the conversion.

After a five-year waiting period, however, all distributions from the Roth IRA are tax-free. More sophisticated IRA-repositioning strategies using charitable remainder trusts, life insurance and more are available.

In next week’s issue of Retirement Watch Weekly, I’ll share more strategies you can use in your retirement years to minimize your adjusted gross income.



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