The most important number on your federal income tax return is on line 37, the last line on the first page of Form 1040. It’s your adjusted gross income (AGI). For retirees, AGI is even more important than for most other taxpayers.
Your taxable income used to be the most important line on your return, and many people believe it still is. Things changed very gradually over the years, making AGI the key to reducing your tax burden.
When AGI exceeds certain levels, what I call the Stealth Taxes are triggered. Under the Stealth Taxes, tax benefits are reduced or additional taxes and surtaxes are imposed. For example, there’s the Medicare premium surtax and inclusion of Social Security benefits in gross income. Personal and dependent exemptions and itemized expense deductions might be reduced. The 3.8% net investment income surtax can be imposed. The list goes on.
Some states now are using AGI to impose their own Stealth Taxes. Surtaxes on New York property taxes are imposed as AGI rises. Various government benefit programs also use AGI to determine eligibility.
This means-testing, in which higher-income individuals pay higher taxes or receive lower benefits, is likely to increase. Governments at all levels have promised benefits for which they can’t pay. AGI is likely to be even more important in deter- mining taxes and benefits.
Tax reduction used to focus on reducing taxable income, for example, by increasing itemized deductions such as mortgage interest and charitable contributions. You’re likely to benefit more, however, from strategies that reduce AGI.
Be careful about which strategies you use. Some strategies reduce AGI today only to in- crease it in a few years. If you’re still working, for example, you can reduce AGI by mak- ing the maximum deferral to a 401(k) plan ($18,000 in 2017 or $24,000 if you’re 50 or older). Or if you and your spouse aren’t cov- ered by an employer retirement plan, you can make a deductible IRA contribution ($5,500 in 2017; $6,500 for those 50 and older).
These strategies only defer AGI. In fact, they increase AGI in the retirement years, when you’re already likely to have troubles with the Stealth Taxes. Instead, focus on strategies that will keep AGI low during the post-career years instead of deferring AGI until then.
Tax-exempt interest. Tax-exempt bonds generate more after-tax interest income than taxable bonds for those in the highest tax brackets, and sometimes for those in lower brackets. For example, the Vanguard Intermediate-Term Investment-Grade fund (VFICX) yields 2.64%. If you’re in a combined federal and state 33% tax bracket, VFICX nets you 1.77%. The Vanguard Inter- mediate-Term Tax-Exempt fund (VWITX) yields 2.12%. There likely will be some state income taxes reducing the after-tax yield.
Still, you’re ahead with tax-exempt bonds, and might even be ahead if you’re in a lower combined tax bracket than 33%.
The interest from the tax-exempt fund isn’t included in your gross income, so it’s not in your AGI. So, switching taxable income investments to tax-exempt invest- ments can reduce regular income taxes and Stealth Taxes.
Take your investment losses. Not every investment makes a profit, even for the best investors. Most investors compound their mistakes. They decide they won’t sell a losing investment until it at least returns to the break-even point. A better strategy for in- vestment in taxable accounts is to sell. Then, you have a realized capital loss.
The loss fi st 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 en- tire loss, the additional loss is carried forward to future years to be used in the same way.
You’re likely to end up with more money in the long run when you bite the bullet and recognize the tax loss. That reduces taxes on capital gains and perhaps other income. It also reduces AGI. Plus, you freed up the capital to invest in something else that might perform better. When you like the losing investment for the long term and expect it to turnaround, you can wait more than 30 days after the sale and repurchase it. That avoids the “wash sale” rules that would defer the loss deduction.
Maximize health savings accounts. Many employers have changed medical insurance benefits to high-deductible plans that make employees eligible for health savings accounts (HSAs). An HSA is the best tax shelter vehicle available.
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 $6,750 in 2017 when you have family coverage or $3,400 when you have individual coverage. Add $1,000 when you are age 50 or older. Contributions aren’t allowed once you join Medicare.
You can invest the account, and all in- come and gains compound tax free. Finally, when you withdraw money and use it for qualifi d medical expenses, the distribu- tions are tax free.
There’s no minimum age for taking HSA distributions. I recommend letting the account accumulate until retirement when medical expenses are likely to be higher, unless significant, unexpected medical expenses are incurred before then. See our April 2015 issue for details about using HSAs.
Restructure traditional IRAs. Required minimum distributions (RMDs) from traditional IRAs and other retirement accounts after age 70½ play havoc with in- come tax planning. 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.
There are ways to avoid having RMDs force you to pay higher income taxes and the Stealth Taxes.
You simply can empty the IRA early. Take distributions and pay the taxes now, so you won’t be hit with 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 strategies using charitable remainder trusts, life insurance, and more also are available. See our August and February 2016 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 tradi- tional IRA. In 2015, Congress made per- manent the qualifi d charitable distribu- tion exclusion. When your IRA custodian transfers money from your IRA directly to a charity you designate, the distribution isn’t included in your gross income (or your AGI). In addition, it counts toward your RMD for the year. You don’t receive a
deduction for the contribution. But it 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. See our May 2016 issue for details.
Don’t overpay state income taxes. This is a good strategy for anyone who itemiz- es expenses on Schedule A and might be subject to Stealth Taxes. You deduct state income taxes on Schedule A, and that reduces taxable income but not AGI.
Suppose you overpay state income taxes for 2016 and receive a refund during 2017.
You deducted those state income taxes on Schedule A for 2016. When it’s time to pre- pare your 2017 federal income tax return, that state income tax refund is included in gross income, which means it is included in your AGI. So, overpaying state income taxes one year increases AGI the next year, potentially increasing the Stealth Taxes.
Manage capital gains. Long-term capital gains have a maximum 20% income tax rate. But many people overlook that you still include the net capital gains amount in gross income, and the gains increase AGI. So, taking a lot of tax-favored capital gains can trigger Stealth Taxes.
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 off et them. Or, if it’s late in the year, consider sell- ing part of the investment now and the rest in a few months when you’re in a different taxable year.
Also, take a close look at your mutual funds. A fund that invests well but gener- ates a lot of taxable distributions each year is giving you a lower after-tax return than a fund with the same, or even a slightly lower, return but much lower distributions.
Your 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 has to be a real business from which you are trying to generate a profit. You have to operate it in a businesslike manner. You also have to participate materially; 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 on the front page of their tax returns, reducing AGI. When you have family coverage, you can deduct the full premium.
Maximize AGI. Th s seems counterintui- tive, but it’s a good strategy for some people.
You can 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 high capital gains. Take the gains in one year instead of spreading them out. 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 a lot of taxes one year to reduce future AGI.
A variation when you have some flexibility in your income and expenses is to alternate high AGI and low AGI years. Not everyone can do this. But consider taking extra IRA distributions and capital gains one year while deferring any deductions that would reduce AGI. The next year, take only required IRA distributions and other types of income you can’t control, and maximize deductions that reduce AGI. The extra income you generated the previous year helps cover your spending.
You might pay lower taxes over the long term by alternating years when you have high and low AGI instead of having an AGI that is high enough each year to trigger some of the Stealth Taxes.