Long-term Planning Ideas to Reduce AGI
In my article a few weeks back (see "Year-end Strategies to Reduce Adjusted Gross Income") I wrote about the tax savings aspects of reducing your adjusted gross income, or AGI, and more specifically some year-end strategies for doing so.
Recall we said that planning moves which reduce AGI overall can oftentimes yield better tax results than simply decreasing your taxable income through "below the line" deductions. By the way, it is still not too late to adopt some of those ideas for 2019, so I urge you to look back at that column if you missed it.
While those planning ideas were things that could be done in the short run to potentially save taxes this year, there are strategies that take a longer view towards reducing AGI significantly in future years. These are the ideas we want to address today and include the following:
1) Invest money held in taxable investment accounts in growth stocks and mutual funds. Gains from appreciation on investments are typically not taxed until the investments are sold, unlike currently received income such as interest or dividends, which is taxed immediately. Because growth stocks are generally held for longer periods of time, this defers the recognition of gain until a later point in time. Further, long-term gains when recognized are at the present time subject to a lower tax rate than most current ordinary income and can often be offset by harvesting any losses you may have.
2) Consider investing in real estate. Appreciating real estate investments are treated the same as the growth stocks discussed earlier. If the real estate is rental property, you will benefit from depreciation deductions and if the rental activity rises to the level of a trade or business, it may even qualify for the new section 199A 20% QBI deduction, a discussion of which is beyond the scope of our article today.
3) Make oil and gas property investments. To encourage exploration and production of oil and gas and reduce some of the associated risk, the tax code is favorably bent towards such investments. The code allows the deduction of intangible drilling costs and depletion against such income.
4) Include investments in tax-exempt bonds in your taxable portfolio. Because they are tax-exempt, the income from such bonds is never included in your AGI to in the first place. Most states allow a similar exclusion if the bonds are from that particular state.
5) If you qualify, make contributions to a Health Savings Account, or HSA. The contribution itself reduces AGI in the year made, but also income from HSA investments is deferred and is never taxed if used in the future for qualified medical expenses.
6) Convert IRA accounts to a Roth IRA account. This is a bit of a tricky one to navigate because the timing needs to be right. The conversion itself will be a taxable event to the extent that the value of the account converted exceeds any tax basis you may have in the account (such as from nondeductible contributions made). Thus, in the year of conversion it will raise AGI. However, after conversion, future gains and income will not increase AGI because they will not be taxed when ultimately distributed, unlike a traditional account.
7) Consider life insurance and annuity products. Many financial advisors do not consider life insurance and annuity products to be investments (or some would say wise investments) so this could be a somewhat controversial idea. But the fact is, earnings from life insurance products and tax-deferred annuities is not included in AGI and therefore not taxed until withdrawn. Further, insurance death benefits received are generally tax-exempt. Such products may have their place in your planning.
Because these planning ideas involve how you invest your money, it must be said that these should only be done to the extent they are consistent with your overall investment strategy and NOT for tax purposes only. In other words, don't let the tax tail wag the dog when it comes to your investments. Always consult with your investment advisor first to see if they fit into your overall investment plan.
Still, implementation of some or all of these strategies, while taking some time to come to full fruition, can result in significant state and federal income tax savings over the long-term. Further, if you are subject to the extra 3.8% net investment income tax that many higher income taxpayers must pay, they can help save on that extra tax bill as well.