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Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

AGI Planning During Retirement

By: Julia Weaver, J.D., Director, Family Office Services and The Trust Company of Oxford and
Bret Horsfield, Family Office Specialist

Avoiding Costly Threshold Triggers

Retirement is a time in life when there is greater ability to manage Adjusted Gross Income (AGI), as a retiree typically has more control over their sources of income. Along with the obvious income tax bracket management, there are other threshold triggers that can increase costs for retirees.

Planning to avoid these various thresholds requires close attention by a client's entire team of advisors and close integration between a retiree's portfolio management and wealth planning teams. Many strategies to suppress AGI for these purposes will include some element of tax efficient investing and disciplined withdrawal strategies.

The following are key thresholds that can dramatically impact a retiree's tax exposure, as well as other non-tax costs:

Key Thresholds

The Obvious:

  • Top Tax Rates for 2016 – Exceeding the taxable income threshold of $466,950 for married filing jointlyi, will not only cause the taxpayer to bump into the maximum tax rate of 39.6%, but will also increase the long term capital gains (LTCG) tax rate and tax on qualified dividends from 15% to 20%. If the main source of retirement income is from capital assets, exceeding this key threshold can result in a bump in income taxes of over $20,000 per year.
  • Limitations on Itemized Deductions (a/k/a the Pease Limitations) – Itemized deductions, including (most regrettably) charitable deductions, will be reduced by 3% of the amount by which AGI exceeds certain thresholds (up to a maximum haircut of 80% of the itemized deduction). For 2016, these key thresholds in the year of funding are $311,300 for married filing jointly and $259,400 for single taxpayers, with no carry forwardii.
  • Phase-out of Personal Exemptions – The deduction for personal exemptions is reduced by 2% for each $2,500 ($1,250 for married filing separately) that AGI exceeds the same thresholds as set forth for itemized deductions, above.

The Less Obvious:

  • Investment Surtax – A surtax of 3.8% applies to the lesser of Net Investment Income (NII); or (2) Modified AGI (MAGI) exceeding $250,000 for married filing jointly and $200,000 for single, head of householdiii.
  • Medicare premiums – The monthly premiums for Medicare are based upon MAGI from 2 years prior. Therefore, 2016 Medicare premiums are based on 2014 MAGI. The Medicare base premium is available only for single filers with MAGI of $85,000 or less and married filing jointly of $170,000 or less. If MAGI exceeds these thresholds then an additional bracket calculation is necessaryiv.

Strategies to Manage AGI

Retirement Income Withdrawal Sequence

Conventional wisdom and a multitude of planning articles set forth a waterfall schematic for the sources of income during retirement, from greatest to least desirable. This retirement withdrawal sequence is typically portrayed as follows:

  • Income from Required Minimum Distributions (RMDs) from retirement accounts, as necessary.
  • Taxable accounts (under the rationale that deferred growth in other qualified accounts is the key decision driver).
  • Tax deferred retirement accounts.
  • Tax-exempt Roth retirement accounts.

This "one size fits all" strategy might be reevaluated, however, when a client is close to a threshold. Withdrawing first from a taxable account, as a matter of course, could be the additional taxable income that thrusts the AGI or MAGI above one of these key thresholds.

Tax Efficient Portfolio Management
Several effective portfolio management strategies can facilitate AGI management.

Loss and Gain Harvesting
Tax loss harvesting is a strategy to manage AGI and potentially reduce the end-of-year tax bill. This is done by using portfolio losses to reduce the capital gains of other investments on a newly purchased portfolio.

Harvesting tax losses facilitates more robust AGI management and may enable you to defer income (and taxes) to a year when your income and tax rate might be lower. If you have experienced losses in your portfolio and are looking to reinvest anyway, harvesting losses is the proverbial double positive: you change your unwanted position and leverage your losses to lower your tax billv.

In addition to being able to sell at a loss for tax purposes, you can also strategize how to harvest investment gains. In years with lower AGI, holdings with long term capital gains can be sold, thereby absorbing additional AGI away from future yearsvi. Notably, tax gain harvesting is not subjected to the wash sale and you can immediately reposition with a similar portfolio.

Investing in Tax-Free Securities
Management of AGI can also be accomplished through investing in tax-free municipal bonds. There are, however, multiple factors to consider before determining the correct investment based on each individual's circumstance.

An understanding of "tax equivalent yield" is a must in determining the suitability of a new investment in tax-free municipals. This computation factors in the tax savings for municipal bonds in order to compare them appropriately to their taxable counterpart. In an interview with Brendan O'Sullivan-Hale, CFA and the Senior Investment Strategist at Oxford Financial Group, Brendan explained, "Municipal bond yields are currently low, making it expensive for clients to purchase on a relative basis. Unless clients are in the highest two (2) tax brackets, generally speaking, new investments would be better off in a taxable bond because most investors can earn more even after taxes are paid."

Among the most important factors in determining implementation of this strategy are AGI and how it affects tax liability and the amount of funds earmarked for the individual's bond strategy. While investing in taxable bonds may cause an increase in AGI and subsequently MAGI, these increases can be scaled down if the new investment is sizable enough to exceed the tax-equivalent yield. How all of these factors work together is important to understand in balancing bond yield with the effects of said yield.

Brendan elaborated that, with an existing portfolio, "Unrealized gains in an existing bond portfolio should also be considered before making a switch to a tax-free bond strategy as it would have [potentially significant] capital gains tax implications." Brendan discussed that there are exceptions and all factors should be explored in order to make an informed decision.

Charitable Planning
Along with the obvious outright charitable deduction, the Charitable Rollover is a planning strategy that provides a good opportunity for management of AGI during retirement.

  • The Charitable Rollover - Once an individual reaches age 70 ½ and is required to begin taking minimum distributions from their IRA, they may take advantage of this provision. The individual can make up to $100,000 a year in gifts to a public charity directly from their IRA. Those gifts count towards the required minimum distributions they must take annually from their traditional IRAs, but are not included in their AGI. This is the primary tax advantage of the Charitable Rollover. Several caveats apply:
  • There is no double dipping... since the gifts aren't counted in income, you may not claim an itemized charitable deduction for them.
  • The recipient charity may not be a donor-advised fund, supporting organization or a private foundation.
  • The transfer must be made directly from the IRA custodian to the charity.
  • You can contribute more than your RMD, however the total amount gifted may not exceed $100,000vii viii.

There may be other tax advantages due to the various phase-outs and limitations on itemized deductions, including charitable contributions. The transfer will not be subject to the percentage of AGI limitations that apply to charitable deductions. For example, an individual may give and deduct 50% of his or her AGI to public charities in cash and still take advantage of a transfer of $100,000 from his/her IRA to a public charity. Further, the transferred amount may avoid state income taxes.

A Team Effort
AGI management takes a fully collaborative effort with an individual's entire team of advisors. Some strategies involve more complex techniques, including timing around recognition events, decisions on executing on various disclaimers or whether to exercise options to defer income or whether to elect deferral on various installment agreements. An individual's entire wealth management team, including legal and tax advisors, should be consulted for all recommendations.

Don't Let Perfect Get in the Way of Good
The management of AGI can be an onerous proposition. Certain entity and trust distributions are simply outside the control of taxpayers in many instances, making it nearly impossible to precisely monitor this issue throughout the year.

However, when AGI is creeping up toward a threshold, robust management of income sources can have a dramatic and positive impact on taxes and other costs.

iThe 39.6% taxable income thresholds for single and head of household taxpayers is $415,050 and $441,000, respectively.
iiFor 2016, other thresholds are $285,350 for head of household and $155,650 for married filing separately.
iiiOther MAGI thresholds for the surtax are $125,000 for married filing separately and $12,400 for trusts and estates.
ivFor example in calculating 2016 Medicare premiums, if a single filer had 2014 MAGI between $160,001 and $214,000 or a married filing jointly filer had MAGI between $320,001 and $428,000, the premium is $316.70. However, if 2014 MAGI exceeded $428,000 for married filing jointly and $214,000 for single filers the premium increased to $389.80.
vThere are also limitations on loss harvesting. The IRC prohibits investing in what the IRS categorizes as a "substantially identical" investment within 30 days (before or after) the sale of the security. This rule is designed to limit selling and repositioning in the same or an extremely similar investment in an attempt to avoid taxation. If the new investment is "substantially identical" to the initial investment, the IRS deems this as a "wash sale" and you will not be able to leverage any losses to improve your tax situation.
viNotably, tax gain harvesting is not subjected to the wash sale and you can immediately reposition with a similar portfolio.
viiThe gift can be made in satisfaction of a charitable "pledge", but as with as with any charitable contribution, the taxpayer may not receive anything (other than an “intangible religious benefit”) as quid pro quo for the contribution.
viiiThe Charitable Rollover may not be made from a Simplified Employee Plan (SEP) or Savings Incentive Match Plan for Employees (SIMPLE plan) if an employer contribution is made for that year.