How often do you really look at your tax return and see what it’s telling you? I know it’s a relief to get it over with for another year, but it could save you a bunch of money to take the time to do a little detective work.

As your financial life gets more complex, so does your tax return. It’s easy to get lost in all those pages and forget to focus on a few numbers that could affect your financial strategy. Let’s identify key numbers in your tax return. After you identify these key numbers, we can move on to diagnosing issues you may want to further consider.

When I reference “line numbers” in this next section, I’m referring to the 2020 U.S. 1040 Tax Return.

Marginal Tax Bracket

When you look at your Taxable Income (line 15), what bracket does your income fall into? You can use the Tax Cheat Sheet later in this article for the most common tax brackets. Or you may find a reference to it in the documentation your CPA gives you if he or she prepares the return.

Effective Tax Rate

Divide Total Tax (line 24) by Taxable Income (line 15). This is how much tax you pay after taking out deductions. This is what you REALLY pay in tax. Use this when you think about strategy.

Capital Gains Tax Bracket

Take a look at your Taxable Income (line 15) and compare it to the current capital gains brackets (see our Cheat Sheet again). If your income is lower, or has dropped because you retired before age 72, you may be able to make use of the 0% capital gains rate bracket. As with ordinary income tax, capital gains tax brackets are graduated. You “fill up” the lower brackets first and then move into the higher tax brackets. When you sell an investment, you trigger capital gains or losses. You can net long-term and short-term gains and losses if you have them.

Because the capital gains tax is a graduated system, the 0% bracket is not unlimited. When your taxable income gets above a certain threshold, you’ll pay at higher capital gains rates. Just to blow your mind, while you use Taxable Income to calculate your capital gains bracket, you use Modified Adjusted Gross Income to see if you have to pay the Medicare surtax (3.8%) that is tacked on top of your capital gains bracket. Thanks IRS.

Adjusted Gross Income (AGI)

Line 11. Income before deductions. Important when calculating other key financial numbers like how much you can deduct for charity or how much you pay in Medicare premiums.

Distributions from IRAs

Take a look at Lines 4a and 4b. This is the difference between total IRA distributions and taxable IRA distributions. Not all of an IRA distribution may be taxable if you have after-tax contributions. Once you are over age 72 (and for those who turned 70 ½ before 2020), you are required to take out money from IRAs.

Did you make a Qualified Charitable Distribution (QCD) from an IRA if you are over age 70 ½? If so, they are not taxable and will not increase AGI. QCDs are not reported to the IRS or your CPA. You have to tell your CPA so they can make that adjustment to your Required Minimum Distribution (RMD). There are some tricky rules with QCDs if you are still contributing to an IRA while also making QCDs. So check with your financial advisor or CPA to make sure you do what’s best for your situation.

Interest and Dividends

Especially when working with high net worth or ultra-high net worth clients, I like to ponder lines 2 and 3. Just the interest on very large brokerage accounts can be staggering. Often these assets have low cost basis, so you can’t just sell them without triggering a large capital gain. But you can “turn off” dividend reinvestment so that you aren’t aggravating the problem of having too much invested in an over-concentrated position.

Or perhaps you are now in a higher tax bracket and need to consider tax-exempt bonds instead of taxable bonds. This may be a clue to think about when planning your portfolio strategy.

When you look at Schedule B (where you list your interest and dividend income), if you see lots of line items, perhaps it’s time to try to consolidate and simplify some of those accounts.

Capital Loss Carry Forwards

As a financial advisor, I’m always delighted to find these on Schedule D, line 16 (especially for a NEW client!). Of course you may be less delighted because if you have a loss here, you lost money on an investment. Still, it’s the silver lining that gives you a free pass to net out future capital gains. If you don’t have any realized gains to net out, you can deduct up to $3,000 a year of capital losses against ordinary income. These loss carry forwards continue indefinitely.

Charitable Carry Forwards

If you look at Schedule A, lines 11 through 14, you’ll see if you have any charitable contributions that will carry forward to a future year. Our current tax law allows you to give up to 60% of AGI to charity in any one year for contributions made in cash. You can take 30% of AGI if you gift marketable securities. You may be limited to 50% of AGI if you do a combination of cash and securities.

For 2020 and 2021, the CARES Act allows you to deduct up to 100% of AGI as long as the contribution is in cash and not to a Donor Advised Fund or family-funded private foundation. You can use a combination of old and new rules to give up to 100% of AGI in a combination of cash and stock (limited to 30% of AGI). Be thoughtful about using the lower brackets to your advantage so you keep taxes lower over multiple years.

Line 13 of Schedule A shows you any charitable gifts that were carried forward from a prior year. If you see “Limited” on Line 14, it means part of your current charitable contributions (combined with prior carry forwards) will be carried forward and can be used in the next five years.

Charitable “Bunching”

If you find that you can no longer take a charitable deduction because your total deductions (Schedule A, line 17) don’t exceed the Standard Deduction ($12,550 for Single, $25,100 for Married Filing Jointly for 2021)*, consider “bunching” deductions. That just means making more contributions in one year and less in future years. You stagger when you give the contributions so you can get over the Standard Deduction, at least in some years, and deduct what you give to charity. Lots of people use Donor Advised Funds to accomplish bunching.
*Higher if over age 65 or blind

Form 8606

Did you make any non-deductible traditional IRA contributions? Lots of higher income taxpayers choose to make a deduction to their traditional IRA to get the tax-deferred compounding over time. When you use dollars that have already been taxed to make your non-deductible IRA contributions, you have tax basis that doesn’t count as income when you pull money out later. This has to be reported to the IRS on Form 8606. If you didn’t tell your CPA you did this, he or she won’t know to file the form. I’ve seen several situations where people had to retroactively amend prior tax returns to add Form 8606.

  • This form is also used when you rollover a 401(k) account where you made after-tax contributions.
  • If you convert any or all of your traditional IRA to a Roth IRA, you’ll also need to include that on Form 8606.
  • If you convert a traditional IRA that was made with mostly non-deductible contributions, you may owe very little in tax. Those original contributions aren’t taxed when you convert, so you’ll only owe tax on any growth on the account.

Using Key Tax Numbers in your Planning

Now that you know what to look for, let’s think about how to use them in your financial planning strategies.

  • Effective tax rate: use this instead of marginal rate in most planning analyses. It’s a truer measure of what you’re actually paying.
  • Bracket Planning: you may want to find ways to fill up the lower brackets by taking income (from a retirement account for example) so that you pay less in tax over a longer time period.
  • Capital loss carry forwards: these can be helpful if you want to reposition your portfolio and you need to take gains.
  • AGI: If you are right near the threshold of paying higher Medicare premiums, keep this number in mind. You can use strategies like making Qualified Charitable Donations from an IRA to keep AGI lower. That would avoid the ordinary income typically generated by a required minimum distribution once you’re past age 72.

Tax bracket planning is the process of analyzing multiple years of tax projections to see if you can save money by spreading out tax impacts over a span of years. A classic example of this is thinking about Roth IRA conversions in the years directly preceding age 72 when you have to start taking required minimum distributions from retirement accounts.

Diagnostic Questions

  • What marginal tax bracket will you be in this year? If you are in the 24% bracket or lower, consider whether a partial Roth RIA conversion may make sense.
  • Will modified adjusted gross income (AGI) be over $200,000 (single) or $250,000 (MFJ)? If so, you’ll have to pay a surtax (3.8%) on top of capital gains rates.
  • If your earned income is over $200,000 (single) or $250,000 (MFJ), you will also hit a .9% Medicare surtax.
  • What capital gains bracket will you be in this year?
  • If you are over age 70 ½, you can make charitable distributions from IRAs up to $100,000 per person per year. When you do that, this distribution is not taxed and will not increase AGI. Do you want to do that?
  • Do you have capital loss carry forwards? Do you want to reposition your taxable accounts and use capital gains from investment sales to net out the carryforward losses?
  • Are your investments in non-retirement (“taxable”) accounts generating more taxable income than you’d like? Can you stop dividend reinvestment? Can you reposition to tax-managed or tax-exempt investments without triggering undue capital gains?
  • Where do you hold different types of investments? Are your income producing investments primarily in your retirement accounts? Can you reposition across investment accounts to be more tax-efficient?
  • Do you want to match a larger charitable donation with a high-income year? If so, setting up a Donor Advised Fund for charitable purposes may help. You get a tax deduction for what you contribute and you can give away the money over a period of years to qualified charities.
  • If you are not over the Standard Deduction, you can “bunch” deductions by giving more in some years (enough to exceed the Standard Deduction) or by contributing to a Donor Advised Fund. Should you do that?
  • Did you have any non-deductible IRA contributions, Roth conversions or 401(k) rollovers with after-tax contributions? If so, don’t forget to file Form 8606 with your tax return.
  • If you rolled over one retirement plan into another, check to see that you are not being taxed on the transaction (assuming you followed the appropriate rules). Lines 4a and 4b.

Tax Cheat Sheets

I like keeping a cheat sheet by my desk for the tax issues that are most likely to come up when working with my clients. Here’s what I need to refer to most often:

2021 Tax Cheat Sheet »2022 Tax Cheat Sheet »

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