Planning 2014’s Taxes with Your 2013 Tax Return

Taxes are one of your largest retirement expenses. Your 2013 federal income tax form is a guide to reducing those taxes in 2014. Before filing away the return for last year’s taxes, take a few minutes to study it. A careful review of the return can point the way to opportunities for decreasing your taxes and increasing after-tax wealth.

Most of the opportunities for those in or near retirement to reduce income taxes are on the front page of the Form 1040. On the back page there are itemized deductions (mortgage interest, charitable contributions, medical expenses, and a few others) plus tax credits. These offer limited planning opportunities for most people. Also, the stealth taxes that increase the burden of many of those in or close to retirement are imposed on adjusted gross income (AGI) or modified adjusted gross income. AGI is the last line of the front page of Form 1040. Examples of stealth taxes based on AGI are the surtax on Medicare premiums, the new net investment income tax under Obamacare, taxes on Social Security benefits, the phaseout of personal exemptions, and the reduction in itemized expenses.

The best opportunities for reducing the special retiree taxes are to reduce gross income and thereby adjusted gross income. Consider these strategies.

Reduce investment income. Does your taxable investment income exceed spending needs? If so, seek ways to shelter the excess. Consider moving money from conservative income investments into deferred fixed annuities. You’ll earn a similar yield, and the income will compound tax-deferred. Or you could contribute some of the money to a Roth IRA. You won’t receive current tax benefits, but the income will compound tax-free and also be tax-free when you withdraw it, reducing your taxes now and in the future.

Stocks paying qualified dividends also are worth considering. These are more volatile than conservative income investments, but the dividends are subject only to a maximum 20% rate, plus most companies that pay dividends increase the dividends each year. This has been a popular sector of the stock markets, so you might want to defer this strategy until valuations are more attractive or carefully choose the stocks.

Consider tax-exempt bonds. Most states and localities are in decent financial shape and aren’t likely to default on their bonds. But tax-exempt bonds declined sharply in 2013 because of rising interest rates and an overreaction to the bankruptcy filing of Detroit. In most tax brackets, you earn a higher after-tax return from highly-rated tax-exempts than from treasuries or even investment-grade corporate bonds. You can buy individual bonds, mutual funds, or closed-end funds to capture the opportunity.

Manage your taxable investments. Reviewing your portfolio a few times a year and making some simple transactions can reduce your tax bill. Most investors don’t do this and leave dollars on the table.

Harvesting investment losses means selling investments that have paper losses to lock in the losses. Deduct these against capital gains (including mutual fund distributions). If your losses exceed capital gains for the year, up to $3,000 of additional losses can be deducted against other income. Any leftover losses after that are carried forward to future years.

Harvesting losses doesn’t mean keeping the investment out of your portfolio forever. If you still like the investment, you can buy it back. With stocks, mutual funds, and some other securities you have to wait more than 30 days to repurchase if you want to deduct the loss in the year of the sale. Or you can buy right away investments that aren’t substantially identical. For example, sell one mutual fund and buy another at a different mutual fund family that has the same strategy.

Consider taxes before selling investments with gains. You save significant tax dollars by holding the investment for more than one year so the gain qualifies as long-term with a maximum tax rate of 20%. Sell a day early and it will be a short-term gain taxed at your ordinary income tax rate.

Even when a gain will be long-term, consider the full picture before selling. A long-term capital gain increases your adjusted gross income. It might be enough to trigger higher taxes on Social Security benefits, higher Medicare premiums, reduction of itemized deductions, and other tax penalties. That’s why I say to consider the full picture before deciding to take a capital gain. Understand the full tax cost.

In other words, don’t trade your investments too much. This is one area in which good tax strategies and investment strategies complement each other. One of the most frequent investment mistakes is trading too much, through either impatience or trying to time the market. A common tax mistake also is to trade too much, racking up taxable gains and missing the advantage of long-term gains.

Look for tax-advantaged investments. We already discussed tax-exempt bonds. You also should consider master limited partnerships. These pay high distributions. In the first 10 or so years you own them, about 85% of the distributions are tax-free. But the tax-free distributions reduce your tax basis, increasing taxes in the future. MLPs also make your tax returns more complicated, and some people avoid them for that reason. But they’re worth considering.

Rental or investment real estate also is worth a look. This is more of a business than investment, because work is involved, and some of it is at inconvenient times. But it has tax advantages that make the efforts worthwhile for some people. You have to meet various requirements, such as being actively involved in management of the real estate, to reap all the benefits. Be sure you know the rules.

Manage retirement plan distributions. Distributions from IRAs and 401(k)s are taxed as ordinary income. Limit withdrawals from retirement plans and annuities to only the amounts needed for spending and required by law or contract. 

Take business loss deductions. Losses from businesses also reduce AGI. Losses can come from a sole proprietorship, partnership, limited liability company, or subchapter S corporation. You might be able to turn a hobby into a business. You have to run the activity like a real business, not a hobby, to meet the IRS’s rules for deducting losses.

Deductions for AGI. There are some deductions you can take on the front page of the 1040 that reduce AGI. They aren’t practical for many people age 55 and over, especially those already retired. The deductions include health savings account contributions, moving expenses, the deductible part of self-employment taxes, self-employed health insurance premiums, and some self-employed retirement plan contributions. There are a few others that don’t involve much planning, such as alimony payments.

By all means, maximize these deductions to the extent you can. But they don’t offer significant planning opportunities for most of those who are in or near retirement.

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