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How to Minimize the Most Important Number on Your Tax Return [Part 2]

Published on: Jul 24 2022
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In last week’s edition of Retirement Watch Weekly, I shared my first three strategies for how minimize your adjusted gross income (AGI). Today let’s go through six more such strategies…

Minimize Your Tax Return’s Most Important Number in Retirement: Strategy #4: 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, Congress made the qualified charitable distribution exclusion (QCD) permanent.

After age 70½, when money is transferred directly from your IRA to a charity designated by you, the distribution 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 someone age 70½ or older to make charitable contributions.

Minimize Your Tax Return’s Most Important Number in Retirement: Strategy #5: 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 mutual 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.

Minimize Your Tax Return’s Most Important Number in Retirement: Strategy #6: The retirement business.

A retirement 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 must 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 premiums from gross income, reducing AGI.

When you have family coverage you can deduct the full premium.

Minimize Your Tax Return’s Most Important Number in Retirement: Strategy #7: 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, convert traditional IRAs and other retirement 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 reasonably 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 consider taking extra IRA distributions and capital gains while deferring any deductions 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.

Minimize Your Tax Return’s Most Important Number in Retirement: Strategy #8: Consider deferred annuities.

This strategy is for retirees and pre-retirees 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 conservative taxable investments.

Minimize Your Tax Return’s Most Important Number in Retirement: Strategy #9: 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 taxable income investments into tax-exempt bonds. But the Stealth Taxes are triggered by modified AGI, not regular AGI.

You add tax-exempt interest, foreign-earned income and a few other sources of tax-exempt income to regular AGI to modified AG for computing the Stealth Taxes. So, there’s a trade-off with tax-exempt 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 worthwhile, but don’t think it will avoid the Stealth Taxes.

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