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Warning: One Wrong Move Can Increase Your Retirement Tax Bill

Taxing Situations

By Kristina Drzal Houghton, CPA, MST

The aging Baby Boomers, still reported to be the largest group of Americans, will continue to put pressure on the U.S. healthcare system and Medicare costs. According to the Census Bureau, by 2030, when all Boomers will be older than age 65, one in five U.S. residents will be of retirement age.

To help the government finance the retirement and Medicare costs associated with this aging group, Congress has come up with some crafty but often overlooked ways to increase funding. This article will discuss not only how retirement taxes may be more of a burden than you may think, but how they might be hiding in places you least expect. One wrong move can increase your retirement tax bill.

Retirees who plan carefully can often pay a lower tax bill in retirement.

“No matter your retirement status, retirement tax planning often means keeping your taxable income under certain thresholds.”

Kristina Drzal Houghton

The process of trying to figure out where to take funds out of to minimize the impact of taxes is pretty complicated, especially when you throw in Social Security taxes and income from other sources. Every person has a unique tax situation, and an advisor can customize an approach to ensure you have enough money to live on in as tax-efficient a way as possible.

No matter your retirement status, retirement tax planning often means keeping your taxable income under certain thresholds. The less you spend in retirement, the less income you need, and, therefore, the less taxes you will pay. It may be important for you to keep below certain income thresholds.

When it comes to Social Security benefits, whether you pay taxes on your benefits will depend on your ‘combined income.’ That is, the sum of your adjusted gross income, non-taxable interest, and half of your Social Security benefits. If you filed as single and your combined income is $25,000 to $34,000 (or $32,000 to $44,000 if you’re married and filing jointly), you can expect to pay income taxes on up to 85% of your benefits. Once again, evening income can help reduce the amount of Social Security subject to tax.

It’s likely you are receiving the extra bill because you’re now subject to the Medicare high-income surcharge, officially called the Income-Related Monthly Adjustment Amount (IRMAA). If this is the case, your bill will say ‘IRMAA.’ You pay this surcharge if your modified adjusted gross income, plus tax-exempt interest income, was higher than $85,000 if you’re single or $170,000 if married filing jointly on your last tax return on file (usually 2018 for 2020 premiums).

This surcharge boosts your monthly Medicare Part B premiums from the standard $144.60 in 2020 to a range of $202.60 to $491.60 per month, depending on your income. This boost also effects Medicare Part D prescription-drug coverage. If you and your spouse file jointly and are both receiving Medicare benefits, you’ll both be subject to the high-income surcharge.

The Social Security Administration uses your most recent tax return on file (generally 2018 for 2020 premiums) to determine whether you’re subject to the surcharge. But you may be able to get the surcharge reduced if your income has dropped since then because of certain life-changing events, such as marriage, divorce, death of a spouse, retirement, or a reduction in work hours. In that case, you can ask Social Security to use your more recent income instead (you’ll need to provide evidence of the life-changing event, such as a signed statement from your employer that you retired).

If you’re near the income cutoff, be careful about financial moves that could increase your adjusted gross income and make you subject to the surcharge, such as rolling over a traditional IRA to a Roth or making big withdrawals from tax-deferred retirement accounts. To stay below the limits, you may want to spread your Roth conversions over several years or withdraw money from a Roth rather than just from tax-deferred accounts.

Additionally, you may decide to fund a larger-dollar expense from after-tax savings rather than additional withdrawals from tax-deferred accounts. Another often-overlooked planning opportunity involves calculating the tax benefit of married filing jointly versus married filing separate and comparing this tax savings to the cost of additional Medicare premiums.

If you are planning on getting a lump-sum payment from a pension or other source, you could be facing a big tax headache. The company paying your benefit is required by law to withhold 20% of the money for taxes. You may be able to avoid the problem if you ask your employer to deposit your pension directly into a rollover IRA. The check cannot be made out to you; it must be transferred directly into the IRA account.

According to the IRS, a required minimum distribution is the minimum amount you must withdraw from your tax-advantaged savings accounts each year. You generally must start taking withdrawals from your IRA, SEP IRA, SIMPLE IRA, or other retirement plan account when you reach age 70 1/2. Roth IRAs do not require withdrawals. Do not withdraw less than the required amount as a way of reducing your income. If you do not make these withdrawals, the IRS will assess a rather large penalty of 50% of the amount that should have been withdrawn.

If you hold investments in a taxable account you plan to draw from in retirement, selling an investment in that account triggers what is known as a capital gain. Capital gains amount to the difference between the sale price and purchase price of the investment and are treated as taxable income in the year you incur them.

Short-term capital gains on investments held for a year or less are taxed at ordinary income-tax rates. The good news: Long-term capitals on investments held for over one year are taxed at lower rates. You’ll pay either 0%, 15%, or 20% tax rate on long-term capital gains depending on your income and filing status.

Realizing a capital gain in years where you pay no tax on the gain is one of the few ways to earn tax-free investment income.

There are some special tax rules that apply only to certain economically advantaged taxpayers.

Additional Medicare tax applies to high earned incomes. This is a tax that works just like current payroll taxes (FICA taxes). It is a 0.9% tax on earned income in excess of $200,000 for singles or $250,000 for married couples.

Additional Medicare tax applies to high investment incomes. This tax is sometimes referred to as Net Investment Income Tax (NIIT). It is a 3.8% tax that applies to investment income if your adjusted gross income is in excess of $200,000 for singles or $250,000 for married couples.

Evening your income on a year-by-year basis can eliminate or avoid this additional tax, which could apply in high-income versus moderate-income years.

Given the volley of taxes that can hit retirees, financial advisors need to work with clients to evaluate which pots of money they should use first as they retire. By having their savings spread across taxable accounts, tax-deferred accounts like your traditional IRA, your 401(k) or your 403(b), or tax-free accounts like your Roth IRA, retirees can manage their withdrawals and minimize the levies they pay. v

Kristina Drzal Houghton, CPA, MST, is a partner and director of the Taxation Division at Holyoke-based Meyers Brothers Kalicka; (413) 536-8510;