Like every summer in Maine, it went by much too fast. But now that fall is here and the end of the year is in sight, it’s a great time to think about crossing off a few of your financial to-do’s. One important project you can tackle is reducing your current-year adjusted gross income (AGI) — which is a tax-smart approach that can save you money in both the short and long term.
What is AGI?
AGI equals all your taxable income items minus selected deductions (e.g. IRA and retirement plan contributions or alimony payments required by pre-2019 divorce agreements).
Reducing your AGI helps lower your year’s taxable income and exposure to unfavorable AGI-based provisions. For example, lowering AGI can increase the amount of Social Security benefits you can receive federal-income-tax-free and increase your allowable higher education tax credits.
Five Ideas for 2019
As 2019 winds down, there are a few actions you can take to reduce your AGI for the current tax year.
1. Sell loser securities held in taxable brokerage firm accounts
Selling securities that lost value in 2019 can be used to offset gains in those brokerage accounts. This will also help reduce your exposure to the 3.8% net investment income tax (NIIT). However, if your account doesn’t have gains to offset, losses aren’t too beneficial for tax purposes, as they’re limited to $3,000 per year. If your net capital loss exceeds this limit, you can carry the loss forward to later years.
2. Gift soon-to-be-sold appreciated securities to family members
As long as the recipient of any gifted securities is in a lower tax bracket, you can help reduce the taxes owed on any gains the security has seen. Beware, however, of the kiddie tax, which can apply until the year your recipient turns 24.
3. Donate appreciated securities, rather than cash, to IRS-approved charities
Doing so will get you a deduction for the full, fair-market value of the donated securities if you’ve held them for more than a year, plus the charity won’t owe tax on any gains. This strategy is particularly useful for higher-income taxpayers as it helps reduce exposure to the 3.8% NIIT.
4. Maximize deductible contributions to tax-favored retirement accounts
Contributing to 401(k) accounts, self-employed SEP accounts, self-employed SIMPLE IRAs and other tax-favored retirement accounts is a great way to reduce your AGI and increase your retirement savings. So contribute to these accounts as much as is allowed and that you can comfortably afford.
5. Defer revenue from small businesses and accelerate business expenses
If you’re a cash-basis self-employed individual, there are steps you can take to postpone collections until 2020 or, conversely, accelerate deductions taken in 2019. For example, you might delay billing a customer until January for work completed near year end, or you might prepay deductible business expenses using a credit card.
Five Long-Term Strategies for Future Years
As you can see, there are certainly steps you can take right now to help reduce your AGI before 2019 ends. But to see an even greater impact over a greater period of time, you should think more proactively and more long term. These moves, some of which may cost you extra now, could significantly save you in taxes over the long run — especially as you move up into another tax bracket or if tax rates increase in the future.
1. Convert traditional retirement account balances to Roth accounts
Taxable distributions that result from Roth conversions will increase AGI and potentially your exposure to the 3.8% NIIT in the conversion year. However, income and gains that build up in a Roth IRA won’t be included in your AGI in future years. That’s because qualified Roth distributions are free of federal-income-tax and the 3.8% NIIT.
In contrast, the taxable portion of distributions from other types of tax-favored retirement accounts and plans will be included in your future-year AGI. Plus, they’ll increase your future-year exposure to the 3.8% NIIT.
2. Invest taxable brokerage firm account money in growth stocks
Gains aren’t taxed until the stocks are sold. And when you do sell, the negative impact of those gains can be offset by selling losing securities. Conversely, stock dividends are taxed currently and can be more difficult to offset.
3. Invest more taxable brokerage firm money in tax-exempt bonds
Use tax-favored retirement accounts (such as a Roth) to invest in securities that are expected to create taxable gains, dividends and interest. Then, use your taxable brokerage accounts on tax-exempt securities that will reduce your future AGI and exposure to the 3.8% NIIT.
4. Invest in rental real estate and oil and gas properties
Rental real estate income can be offset by depreciation deductions while oil and gas income can be offset by deductions for intangible drilling costs and depletion.
5. Invest in life insurance products and tax-deferred annuity products
Life insurance death benefits are generally exempt from both federal income tax and the 3.8% NIIT. Earnings from life insurance contracts and tax-deferred annuities aren’t taxed until they’re withdrawn.
Multiple Levels of Tax Savings
Many of these strategies can potentially lower both your regular federal income tax (FIT) bill, your exposure to the NIIT and your Maine personal income tax. And if you’re self-employed, they may also reduce your self-employment tax bill.
However, some of these strategies can take time to fully implement and pose issues that can carry over into other areas of your finances. If you have questions or would like help in reducing your AGI, contact us here at Filler & Associates.