Year-End Planning:How To Reduce 2010 Adjusted Gross Income (AGI)
Last time, we discussed who should consider reducing AGI for 2010. So just how do you do that? This article presents some of the ways of lowering 2010 AGI for year-end planning purposes.
Not all steps listed below will be available or desirable for everyone, but many whose income without any planning would be in the range of a threshold may be able to use one or more of the following strategies to keep AGI below the applicable level:
- Convert taxable interest to tax-exempt interest. This will be especially practical where you will recognize little or no gain on the disposition of a taxable investment, such as when shifting funds in a taxable money market account to a tax-exempt fund. The tax-exempt interest will not be included in AGI, and for some, the after-tax amount received from tax-exempt interest will be at least as much as the after-tax amount received from taxable interest. That's especially true if the tax-exempt interest is exempt from state or local income taxes too.
Caution: Taxpayers who might be subject to the alternative minimum tax (AMT) should usually avoid investing in tax-exempt private activity bonds since the interest on those is subject to AMT even though not included in AGI.
- Convert taxable interest to tax-deferred interest. Instead of leaving funds in accounts generating taxable interest, consider shifting funds to U.S. Series EE bonds or inflation-indexed Series I bonds. Unless you elect otherwise, "interest" on such bonds isn't taxed until the bonds mature or are redeemed.
Another possibility would be to buy Treasury Bills with a term of one-year or less that mature in 2011 so that the income from the Bills won't be included in income until that year.
Alternatively, you could shift funds from investments that produce currently taxable income to beaten-down growth stocks, which pay little or no dividends and give you the ability to control when any gain on the stocks will eventually be realized by timing their sale to suit your tax goals.
- Pay off debts. If you have both income-generating investments and debts on which you are paying interest, consider selling part of your investments and using the proceeds to retire debt. In addition to reducing AGI, this may increase your net income because the reduction in interest payments often is greater than the reduction in the income received on the investment.
Recommendation: If you are reluctant to repay current debt for fear that you may need the capital in the near future, then, if eligible, consider taking out a home equity credit line to draw on in case of need instead of keeping both income earning investments and debt.
- Increase contributions to retirement plans. You may be able to reduce AGI by increasing contributions to retirement plans such as 401(k) plans, SIMPLE pension plans, and Keogh plans.
- Increase contributions to Health savings account (HSA). If you are covered by a qualifying high deductible health plan (and are generally not covered by any other health plan that is not a qualifying high deductible health plan) you may make deductible contributions to an HSA, subject to certain limits.
For 2010, assuming a full year of coverage, the maximum contribution for self-only coverage is $3,050, and for family coverage it's $6,150. In addition, an individual who has reached age 55 before the close of 2010, can make a catch-up contribution of $1,000. Distributions from an HSA to pay qualified medical expenses are not taxable.
An individual's HSA contribution level may be based on expected out-of-pocket medical expenses, but there is nothing to prevent an individual from making deductible contributions up to the maximum allowable amount, regardless of expected expenses. These contributions in excess of medical needs can be withdrawn from the HSA and used for any purpose without penalty (but subject to tax) once the individual reaches age 65.
- Defer receipt of year-end bonuses. An employee who believes a bonus may be coming his way may request that his or her employer delay payment of any bonus until early in the following year. By deferring the bonus, the employee will avoid having it included in 2010 income.
Caution: If an employee waits until a bonus is due and payable to request a deferral, the doctrine of constructive receipt will be triggered and the inclusion of the bonus in AGI will not be deferred.
Also, if the deferral extends beyond two-and-one-half months after the close of the tax year, the bonus will be treated as nonqualified deferred compensation. Bonuses treated as deferred compensation are currently includible in income to the extent not subject to a "substantial risk of forfeiture" if the arrangement fails to meet certain distribution, acceleration of benefit, and election requirements.
The impact of the 6.2% Social Security portion of the FICA tax may also affect the timing of a bonus. For example, if an employee is retiring in 2011, the employee's salary alone may exceed the Social Security wage base in 2010 ($106,800) but not in 2011. As a result, postponing a bonus payment from 2010 to 2011 could convert a bonus exempt from the 6.2% tax into a bonus subject to that tax.
- Pay up to $2,500 of student loan interest. Up to $2,500 of student loan interest paid during a tax year is deductible in computing AGI. A taxpayer should consider deducting up to this amount in a tax year even if less than that amount is required to be paid in that tax year.
Observation: Under sunset rules, after 2010 (unless Congress acts) the above-the-line student loan interest deduction (1) phases out over lower modified AGI ranges and (2) applies only to interest paid during the first 60 months in which interest payments are required. The possibility of more stringent rules next year makes accelerating student loan interest deductions into this year more worthwhile.
- Pay back alimony in 2010. Someone required to pay alimony to a former spouse is entitled to deduct that alimony in the year paid. Accordingly, consider paying any alimony owed for prior years in 2010, since the full amount paid in 2010 will be a deduction from AGI.
- Pay moving expenses in 2010 even if move isn't made until 2011. Residential moving expenses are deductible (including from AGI) in the year paid or incurred. Thus, where someone pays professional movers in December of 2010, but the actual move isn't made until January of 2011, the taxpayer is entitled to the deduction on his 2010 return.
