How to Minimize the Most Important Number on Your Tax Return

The most important number on your federal income tax return, especially during retirement, is on line 11 of the first page of Form 1040 for 2021. The number is your adjusted gross income (AGI). For retirees, AGI is more important than for most other taxpayers.

Before retiring, taxable income probably is the most important line on your re- turn, 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 re- duced or additional taxes and surtax- es 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 de- ductions.

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 im- pose 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 individu- als 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 manag- ing 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 max- imum 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.

Take your investment losses. Any- one 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 wait- ing more than 30 days after the sale.

hat avoids the “wash sale” rules that would defer the loss deduction. 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 ex- penses, 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. See our August 2021 and September 2021 issues for details about using HSAs.

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 strat- egies 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-reposition- ing strategies using charitable remain- der trusts, life insurance and more are available. See our March 2020 and April 2020 issues for ideas.

Be charitable with your IRA.

When you’re making charitable contributions each year and are at least age 70½, make those contributions through your traditional IRA. In 2015, Con- gress made the qualified charitable dis- tribution exclusion (QCD) permanent.

After age 70½, when money is transferred directly from your IRA to a charity designated by you, the dis- tribution isn’t included in your gross income (or your AGI). In addition, the distribution counts toward your RMD, if you’re required to take one that year. You don’t receive a deduction for the contribution.

But the QCD stays out of your AGI, reducing income taxes and the Stealth Taxes. It’s probably the best way for some- one age 70½ or older to make charita- ble contributions. See our April 2022 issue for details. Manage capital gains.

Long-term capital gains have a maximum 20% income tax rate, and most retirees pay a lower rate. Many pay a 0% rate on long-term gains. But net capital gains increase AGI. So, while long-term capital gains face a favorable tax rate, taking a lot of gains can trigger Stealth Taxes, effectively increasing the tax rate on capital gains.

That’s why you need to be careful about taking long-term capital gains. When taking a gain in a taxable account is the right investment move, look for losses you can take to offset it. Or, if it’s late in the year, consider taking part of the gain now and the rest in a few months when you’re in a different taxable year. When you need cash and have a choice of its source, consider a tax-free source such as a Roth IRA or an HSA before selling assets for capital gains.

Also, take a close look at your mutu- al funds. A fund that invests well but generates a lot of taxable distributions each year could be giving you a lower after-tax return than a fund with the same, or even a slightly lower, return but much lower distributions. The retirement business. A retire- ment business can generate several tax benefits.

First, if the business has tax losses from time to time, the losses reduce gross income and thereby reduce AGI. To deduct losses, it must be a real business from which you are trying to generate a profit. You have to operate it in a businesslike manner. You also must materially participate; you can’t be a passive investor who lets others run it if you want to deduct losses.

Second, self-employed individuals can deduct their health insurance pre- miums from gross income, reducing AGI. When you have family coverage you can deduct the full premium. Maximize AGI some years. This is counterintuitive, but at times it’s a good strategy for retirees.

Maximize AGI one year so that it is low in future years. For example, con- vert traditional IRAs and other retire- ment accounts to Roth accounts. You’ll pay higher taxes in the year of the conversion but have lower AGI later.

You also can sell investments you’ve held for a long time and that have significant capital gains. If you spread the gains over the years, they might keep your AGI high enough to trigger Stealth Taxes every year. But if you take a lot of the gains one year, the Stealth Taxes might be triggered that year but avoided in future years.

You might have other types of income or gains that can be accelerated into one year. Do some careful tax planning before using this strategy.

You might even want to work with a CPA. Be reason- ably sure that you’ll benefit over the long haul by paying higher taxes one year to reduce future AGI. Keep in mind that income and capital gains tax rates could increase in the future, making it more beneficial to pay some taxes now.

When your income and expenses are flexible, a good strategy might be to alternate high AGI and low AGI years.

Not everyone can do this. But consid- er taking extra IRA distributions and capital gains while deferring any de- ductions that reduce AGI in one year. The next year, take actions to minimize AGI. The extra income you generated the first year helps cover your spending in the second year.

One year you’ll pay some Stealth Taxes, the next year you might not. That could be better than paying the Stealth Taxes every year. Consider deferred annuities.

This strategy is for retirees and pre-retir- ees who have money that’s invested conservatively in taxable accounts and who don’t need to spend the interest income each year. They’re letting the interest compound for the future. That interest is included in your gross income and AGI each year.

You’re paying both income taxes and perhaps the Stealth Taxes on it. A better strategy might be to move some of those assets into a deferred fixed annuity or a deferred indexed annuity. The money will earn interest, but it will compound tax deferred.

Income and Stealth Taxes won’t be due until the interest income is distributed to you, and you have some control over when that happens. The annuity also is likely to earn higher rates than conser- vative taxable investments. For details about current yields on deferred fixed annuities, go to www.stantheannuity- man.com. For details about deferred index annuities, contact Todd Phillips at 888-892-1102.

Recognize the tax-exempt interest trap. Interest on bonds issued by state and local governments is exempt from federal income taxes. It isn’t included in gross income. Many people think they’ll avoid the Stealth Taxes by moving all their tax- able income investments into tax-ex- empt bonds. But the Stealth Taxes are triggered by modified AGI, not regular AGI.

You add tax-exempt interest, for- eign-earned income and a few other sources of tax-exempt income to regu- lar AGI to modified AG for computing the Stealth Taxes. So, there’s a trade-off with tax-ex- empt bonds.

They will reduce your regular income taxes but might not save you from Stealth Taxes. The regular income tax savings can make investing in tax-exempt bonds worth- while, but don’t think it will avoid the Stealth Taxes.