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Avoid the Income Funnel Trap

To reduce income tax, do what you can to limit the flow of items into the top lines of your tax return.

Once a fish swims into a funnel-type fish trap, he can just about never swim out again. So it is with our income tax system. Once "income" goes into the wide mouth of the trap, avoiding tax is like swimming upstream. To minimize taxes, you need to concentrate on "above-the-line" deductions that reduce adjusted gross income, and (better yet) on getting the types of income that avoid the funnel altogether.

Here's how the federal income tax system works. "Gross income" is swept into the wide mouth of the trap, bringing you to line 22 of your Form 1040 ("Total income"). Then you get to reduce this number by taking certain highly favored deductions, to arrive at adjusted gross income (line 37). Finally, you take out some not-quite-as-good but still pretty good deductions to arrive at taxable income (line 43). One of our five different personal income taxes is then imposed on this number.

(Our other four income taxes--alternative minimum tax, FICA/self-employment tax, 3.8% tax on net investment income, and state/local income tax--will have to wait for another column.)

Once you get down to the taxable income line you're pretty much stuck. You'll have to pay tax on that number. If you want to reduce your income tax, you need to start back earlier in the process: Try to reduce the flow of items into the top lines of the tax return and maximize the deductions you can take along the way down through the funnel.

The Mouth of the Funnel: Gross Income
You receive "income" or other accretions to your wealth. The first question about each such receipt is whether it goes into "gross income" for federal income tax purposes. The best income is the income that does not go into gross income at all. If the item is excluded from gross income, it will never increase your taxable income.

Here are some kinds of income that stay out of the funnel:

  • Qualified distributions from a Roth IRA or designated Roth account. These tax-free distributions are the gold standard. The only drawback of taking a qualified distribution out of your Roth plan is that it will no longer be generating more tax-free returns inside the plan.
  • Qualified charitable distributions from your traditional IRA. For the over-age-70 1/2 IRA owner, payments direct to charity from the IRA bypass the income tax system, even when used to fulfill the required minimum distribution.
  • Any distribution from a health savings account that is matched with an unreimbursed qualified medical expense. The medical expense can have been incurred any time since you have owned an HSA.
  • Municipal bond interest--except this income does count in determining how much of your Social Security benefits will be taxable.
  • Part or all of your Social Security benefits. Under a complicated formula, 15%, 50%, or 100% of your Social Security benefits will be tax-free depending on how much other income you have.

Escape Hatch: Adjusted Gross Income
So let's say that after excluding the above items you still have some gross income from your work, investments, minimum distributions from traditional retirement plans, and/or the taxable portion of your Social Security benefits. Now apply the juicy above-the-line deductions that whittle that number down into "adjusted" gross income such as:

  • If you are self-employed, your health insurance premiums are deductible here. That includes premiums for Medicare and long-term care insurance. Result: The first few thousand dollars of self-employment income are income tax-free for the typical older individual, because they offset dollar for dollar against health insurance premiums. However, such income does attract self-employment tax, so it's not a total freebie.
  • Contributions to a workplace retirement plan--such as, for an employee, a 401(k) plan, or for the self-employed, a solo-401(k) or a SEP-IRA. (Roth contributions do not have this effect.) Of course these contributions merely defer the income, they don’t eliminate it altogether.

The resulting number, "adjusted gross income" not only feeds into the ultimate "taxable income" number, it also can raise or lower your taxes and costs in other ways. For example, your Medicare premiums in 2020 will be higher or lower depending on your AGI in 2018. Whether you are subject to the 3.8% net investment income tax depends on whether your AGI exceeds $200,000 (if single) or $250,000 (married filing jointly).

Last Chance: Taxable Income
Finally, you get a last chance to lower your tax with itemized deductions, such as state and local taxes (deduction now limited to $10,000), mortgage interest (other limits apply), medical expenses (if in excess of 7.5% of AGI--there it is again!), and charitable contributions. Or instead of itemized deductions, you can take the new higher standard deduction--$24,000 for marrieds filing jointly (plus $1,300 for each spouse over 65) or $12,000 for singles (plus $1,600 if over 65).

Note how the "top of the funnel" affects the end of the funnel: A Roth distribution that is kept out of gross income not only is a good tax-free bit of income itself, it also reduces AGI (compared to a taxable traditional IRA distribution), which may lower Medicare premiums two years out, lower net investment income tax, and/or increase the medical expense deduction. A charitable contribution paid by means of a "qualified charitable distribution" from the IRA can have the same effects--and/or it may enable the IRA owner to use the standard deduction while also in effect getting a 100% "charitable deduction" to offset against his IRA distribution that (because it went directly to charity in the form of a QCD) and never entered the top of the funnel.

Where to read more: For all aspects of Roth retirement plans, see Chapter 5 of Natalie Choate's book, Life and Death Planning for Retirement Benefits. Regarding health savings accounts, see Internal Revenue Code § 223 and IRS Publication 969. 

Natalie Choate practices law in Boston with Nutter McClennen & Fish LLP, specializing in estate planning for retirement benefits.The views expressed in this article may or may not reflect the views of Morningstar. The electronic version of Natalie’s book, Life and Death Planning for Retirement Benefits, is now on a new platform with expanded features. The e-book gives you the entire book in word-searchable format, plus two chapters (on life insurance and annuities in retirement plans). Visit www.retirementbenefitsplanning.net to subscribe or learn more.