Why Line 11 Is the Most Important Number on Your Tax Return

When you’re in or nearing retirement, the most important number on your income tax return isn’t gross income or taxable income. It isn’t even the total tax bill.

You want to closely monitor line 11 on the first page of the 2023 Form 1040, your adjusted gross income (AGI).

Congress knows retirees have the bulk of the country’s income and wealth, but few elected officials want to increase tax rates directly, especially on middle-class retirees.

So, they enact what I call the Stealth Taxes. The Stealth Taxes increase your tax bill without directly increasing your tax bracket.

Most people monitor their taxable income and where it falls in the income tax brackets. They know how much additional taxable income will push them into the next higher tax rate bracket, or how much taxable income must decline to fall into a lower bracket.

But when you’re in or near retirement, it’s more important to monitor the Stealth Taxes.

When you’re hit with a Stealth Tax, your income tax bill increases though you stay in the same income tax bracket.

AGI is the key to the Stealth Taxes.

When line 11 of Form 1040 exceeds certain levels, Stealth Taxes are triggered. Each Stealth Tax is different, but generally they reduce tax benefits or impose additional taxes and surtaxes.

The major Stealth Taxes for retirees and near-retirees are the inclusion of Social Security benefits in gross income, the Medicare premium surtax and the 3.8% net investment income tax.

The 2017 tax law suspended two other Stealth Taxes at least through 2025, the reductions in itemized expense deductions and personal and dependent exemptions.

Some states also use AGI to impose their own Stealth Taxes. Various government benefit programs use AGI to determine eligibility.

This type of means-testing is likely to increase in the future. 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 between AGI and MAGI matters in only a few circumstances, which I discuss later.)

Be careful when choosing income tax strategies, especially during the working years. Strategies that defer income often reduce income taxes one year but increase both income taxes and Stealth Taxes in later years.

Whether you’re retired or not, consider these strategies to reduce AGI and keep both income taxes and Stealth Taxes low during retirement.

Take investment losses. Taxable investment accounts, such as those at brokers and mutual funds, are likely to have investments with paper 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, no matter how long that takes.

Sometimes, it’s better to sell, realize the capital loss, and redeploy the capital.

A realized loss is deducted against any capital gains for the year, reducing your AGI. If the loss exceeds the year’s gains, the excess loss is deducted against other income up to $3,000, further reducing AGI.

Any additional loss is carried forward to future years to be used in the same way.

When you like the losing investment for the long term, you can repurchase it more than 30 days after the sale. That avoids the “wash sale” rules that would defer the loss deduction. See the March 2023 issue for details about wash sales.

Optimize health savings accounts. A health savings account (HSA) is one of the best tax shelters available. You’re eligible for contributions to an HSA when you’re covered by a high-deductible health plan.

Contributions to the HSA are deductible, or they’re excluded from gross income if an employer makes them on your behalf. Contributions aren’t allowed once you join Medicare.

You can invest the account, and all income and gains compound tax free. Finally, withdrawals used for qualified medical expenses are tax free. They won’t increase your AGI.

HSAs don’t have required minimum distributions for the original owner.

I recommend letting an HSA accumulate until retirement. Then, when extra income is needed, tax-free distributions from the HSA can be taken. See the March 2024 issue of Retirement Watch for details about using HSAs.

Reposition traditional IRAs and 401(k)s. I said earlier that tax deferral can reduce current income taxes but increase future income taxes and the Stealth Taxes. Retirement plans such as traditional IRAs and 401(k)s are the most widely used tax deferral strategies.

Distributions from traditional retirement plans are ordinary income, so they increase AGI. In addition, traditional retirement plans impose required minimum distributions (RMDs) on their owners, increasing AGI, even when the income isn’t needed.

Under the RMD rules, the percentage of the IRA that must be distributed increases each year, so RMDs become a real problem for some people in their late 70s or older.

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

You can simply empty the IRA early. Take distributions and pay the taxes now, and then invest the after-tax amount. 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. See our March 2023 and April 2023 issues for ideas.

Be charitable with your IRA. When you’re making charitable contributions each year and are at least age 70½, have your traditional IRA make those contributions through qualified charitable distributions (QCDs).

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 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.

The QCD probably is the best way for someone age 70½ or older to make charitable contributions. See our February 2024 issue for details.

Manage capital gains. Long-term capital gains have a maximum 20% income tax rate, and most retirees pay a lower rate, often the 0% rate.

But net capital gains increase AGI. So, while long-term capital gains have a favorable tax rate, taking a lot of gains can trigger Stealth Taxes. That increases the effective tax rate on capital gains.

You need to carefully review the entire tax picture before deciding to sell assets with long-term 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 if more capital gains will trigger or increase Stealth Taxes.

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 adding to your Stealth Taxes, reducing your after-tax investment return.

Establish a retirement business. A retirement business can generate several tax benefits.

If the business has tax losses some years, the losses reduce AGI. While a hobby can be turned into a retirement business, for losses to be deductible you must try to generate a profit and operate the activity 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.

Another benefit is that 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.

Maximize AGI some years. This is counterintuitive, but at times it’s a good strategy for retirees.

The idea is to increase income and perhaps Stealth Taxes one year to reduce them in other years. One action we already discussed that has this effect is converting a traditional IRA to a Roth IRA.

Another strategy is to sell investments that have significant capital gains. If you take the gains over the years, they might keep your AGI high enough every year to trigger Stealth Taxes. 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 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.

Some people have enough flexibility in their income and deductions that they alternate high AGI and low AGI years. Not everyone can do this.

In one year, you would take extra income, such as IRA distributions and capital gains, while postponing some deductions that reduce AGI. The next year, do the reverse. Minimize income and maximize deductions.

The extra income taken in 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-retirees who earn interest in taxable accounts but don’t spend all the interest income.

That interest is included in your gross income and AGI. You’re paying income taxes and perhaps the Stealth Taxes on it.

A better strategy might be to move 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 could earn higher rates than the conservative taxable investments.

For details about current yields on deferred fixed annuities, go to www.stantheannuityman.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.

I mentioned earlier that the Stealth Taxes are based on MAGI. The computation of MAGI isn’t the same for all the Stealth Taxes. But for most of them, you start with AGI and add tax-exempt interest, foreign-earned income and a few other sources of tax-exempt income that few retirees have. So, the interest on tax-exempt bonds won’t be subject to income taxes but it could trigger or increase Stealth Taxes.