Five Numbers on Your Tax Return Every Retiree Should Know (Part 1 of 2)

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It's about that time of year again… it's tax time. In my work as a financial advisor, we do a lot of reviewing of tax returns. Many people tend to see their tax return as something they file because they have to, and then store away and never look at again after they get it back from their CPA. My philosophy on tax returns is a little different.

I think of your tax return as a roadmap. It shows you not only what happened in the past, but also provides insight on ways you can lower your tax bill in the future.

When I’m reviewing a tax return with a client, there are a few numbers I always want to know. These numbers help us build a better understanding of where the taxes come from and how to implement financial planning strategies to potentially save more in taxes.

There are obviously a lot of numbers on the form 1040 and accompanying schedules. Today, we’ll focus on five that I think are especially important for retirees to know.

Taxable Income

The first number to highlight is taxable income.

You’ll find it on Line 15, page 2 of Form 1040.

This number tells you what marginal tax bracket you’re in for ordinary income. In other words, if you earned one more dollar of income, what tax rate would apply to that dollar?

For example, if you were in the 12% federal tax bracket last year, then every additional dollar of ordinary income would generally be taxed at 12%. The key point here is there is an upper limit to this tax bracket. Once you cross the income threshold, your marginal rate jumps to the next highest bracket – in this case, 22%.

Knowing your taxable income helps you understand how much room you have to recognize income in your current tax bracket. That can drive decisions such as:

• Whether you should convert to a Roth IRA

• If so, how much to convert?

• Should you take additional IRA withdrawals this year?

• Realizing long-term capital gains

• Are you going to bump your income into a higher marginal bracket?

  
  

When doing tax planning with clients, we’re looking at taxable income to be sure we’re intentional about their marginal tax bracket. In some cases it’s OK to jump into a higher bracket, but we want to be sure additional income is recognized on purpose.

The takeaway: know your taxable income and compare it to the federal tax brackets so you understand your marginal tax rate.

Standard vs. Itemized Deductions

The second number to look at is whether you took the standard deduction or itemized deductions.

You’ll find that on Line 12e of Form 1040.

This tells you how much of your income is being reduced based on deductions and can lower the amount of taxes calculated.

The Tax Cuts and Jobs Act significantly increased the standard deduction amount. For many retirees, it’s the better option rather than itemizing. 

But for others, itemizing still makes sense.

The four most common itemized deduction categories for many retirees are:

• Medical expenses

• State and local taxes

• Charitable giving

• Mortgage interest

  
  

The confusion comes when people think they’re itemizing, when they’re actually taking the standard deduction. They may think they’re getting the tax benefit of one of the four categories above, but that’s only true if their itemized deductions exceed the standard deduction.

For example, let’s say John gave $5,000 to his favorite charity last year. He doesn’t have a mortgage and very little medical expenses, leaving state and local taxes as his only additional itemized deduction. As a single filer over age 65, his standard deduction was $17,750. The amount of the standard deduction exceeded the itemized deductions. This means the charitable gift may not have produced any additional federal tax deduction beyond the standard deduction he would have received anyway. The difference between expectations and reality can be an unwelcome surprise for retirees.

One planning strategy involves bunching donations. Instead of gifting to charity annually, the gift can be made in one year so that the itemized deduction for that year exceeds the standard deduction. Then in other years, they’ll take the standard deduction.

This is an effective way to make full use of your deductions and give in a tax-efficient way.

Takeaway: Look at whether you’re itemizing or taking the standard deduction to adjust your deduction strategy going forward.

Adjusted Gross Income

Number three is a big one: Adjusted Gross Income, or AGI.

This is found on Line 11 of Form 1040.

This number comes before the standard or itemized deduction is applied.

AGI is important because it can trigger all kinds of hidden taxes, phaseouts, and surcharges.

For retirees, it can impact:

• How much of your Social Security is taxed

• Whether you pay additional premiums for Medicare (IRMAA)

• Whether Net Investment Income Tax applies (NIIT)

• Eligibility for certain deductions or tax benefits

  
  

This is where the tax torpedo comes in.

Depending on your income, anywhere from 0 to 85% of your Social Security benefits can become taxable. An increase in AGI can result in a jump in taxes that is disproportionate to your marginal rate.

Using a simplified example, Mary and Joe are married and both 65 years old. They receive $40,000 a year in Social Security benefits. They take $20,000 a year from a traditional IRA.

Their combined income (AGI + 50% of Social Security benefits) is $40,000. They are in the range ($32,000 - $44,000) where 50% of their Social Security benefits may be taxable.

Let’s say they need an additional $10,000 to pay for a home repair project.

If they withdraw it from their IRA, their combined income increases to $50,000. At this level of income, up to 85% of their Social Security benefits may be taxable. Instead of taxes applying to $20,000 of benefits, it now applies to $34,000 of benefits. If they’re in the 12% federal tax bracket, taxes may increase as follows in this simplified illustration:

Tax on the $10,000 withdrawal: $1,200

Tax on the additional Social Security now subject to tax = additional tax

That means the effective tax rate on the withdrawal could exceed their marginal tax rate and be far higher than they expected.

 

AGI also affects Medicare Part B & Part D surcharges, called IRMAA. If your modified AGI goes above certain thresholds, it can increase your monthly costs by significantly driving up the Part B & Part D premiums.

If your income is high enough, it can also trigger Net Investment Income Tax, which is an additional tax of 3.8% on investment income.

If you are wondering why your tax bill has jumped by more than expected even though income didn’t increase very much, understanding Adjusted Gross Income might tell the story.

To be continued...

In addition to:

• Taxable income

• Standard vs. Itemized deductions

• Adjusted Gross Income

  
  

There are two more numbers on your tax return that can provide clarity for retirees in developing their tax planning. They will be covered in detail in next week’s blog post. Stay tuned…

Travis

Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor.  This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.