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Retirement Planning > Spending in Retirement > Income Planning

How Retirees Can Avoid Tax Traps in Social Security, Medicare, Capital Gains

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What You Need to Know

  • The focus of tax planning should be on minimizing a family’s lifetime liability.
  • Retirement tax planning is tricky when it involves Social Security, Medicare and RMDs.
  • Capital gains taxes can be affected by Roth conversions.

When creating a long-term tax plan, the focus should not be on minimizing one year’s tax liability, but rather on minimizing a family’s lifetime liability.

This often takes the form of evaluating a person’s current marginal tax rate and comparing it to their expected future marginal rate. If their current rate is lower, the conventional wisdom is to fill up the lower bracket(s).

But realizing income isn’t always a simple arithmetic equation of adding just enough to stay in a lower tax bracket. Without careful thought, added income could end up being effectively taxed at a higher rate due to how the added income affects other aspects of one’s taxes.

The following outlines several situations in which the tax impact of a change in income affects more than the marginal rate.

1. Social Security

Retirees who are collecting Social Security benefits often miss that the taxable portion of Social Security income depends on how much other income is claimed in a year. Adding a dollar of income could lead to increasing taxable income by up to $1.85 (as 85 cents of Social Security income is also added).

The Story: Nathaniel and Nadia are both 67 years old and started to receive a combined Social Security benefit of $40,000 in 2021.They also will receive $25,000 of taxable income from Nadia’s pension. Their remaining cash flow needs are met through a cash reserve they have in a joint bank account.

Nathaniel has managed their tax plan and assumes the benefits are 100% taxable. Ultimately, he considers a Roth conversion to utilize as much of the 12% tax bracket as possible, bringing their taxable income (after the standard deduction is claimed) to a little under $80,000.

What Nathaniel does not realize is that before any Roth conversion, less than $7,000 of their benefits were taxable, resulting in a taxable income of less than $5,000 and federal income tax of about $500.

After a conversion of $40,000, $34,000 of their Social Security benefit is taxable, resulting in a taxable income of a little over $71,000, or approximately $8,000 of federal tax. In other words, the $40,000 Roth conversion increased their tax liability by $7,500 or an effective rate of nearly 19% — more than 1.5 times the intended 12% rate!

Medicare Premiums

The premium for the Medicare Part B program goes up at different income levels. Even adding $1 of income around these thresholds can move a person from one premium level to another. It is important to be aware of these thresholds when developing a tax plan.

Even realizing income that will be directly offset by a deduction can be expensive. The thresholds for Medicare premiums are impacted by adjusted gross income (AGI). Below-the-line deductions, such as charitable donations, will not help. For this reason, thoughtfully using qualified charitable distributions can produce significant premium savings.

The Story: Quincy, a 74-year-old bachelor, has a sizable IRA with a required minimum distribution in 2021 of $30,000. He also has portfolio income, a pension and Social Security benefits, which add up to $120,000 of income.

Quincy plans to give $30,000 to his favorite charity in 2021. Instead of completing his RMD, pushing his AGI to $150,000 and increasing his Part B premium from $297 a month to $386 a month (an increase of $1,069 for the year), he elects a QCD processed from his IRA.

He will still satisfy his RMD, meet his charitable goals, and maintain an AGI low enough to benefit from the lower premium.

Capital Gains

While short-term capital gains are taxed at regular income rates, long-term capital gains are based on total income. This means that an increase to other income (e.g., through a Roth conversion) could also increase how much of capital gains are taxed.

The Story: Mateo and Maria are retired and have not yet started to collect Social Security. In January of this year, they sold a stock position in their joint account, which had long-term gains of $50,000.

They require another $75,000 to meet their cash flow needs on the year and are trying to determine if they should take it from the IRA, their reserves, or a combination of both. They believe they will be in a higher tax bracket when they start Social Security and RMDs, and lean toward taking the $75,000 distribution from the IRA as it would be taxed at the 10% and 12% rates.

While the IRA distribution will be subject to their marginal income tax rates, it also will impact the taxation of their capital gains. Prior to any IRA distributions, their long-term capital gains were subject to a zero percent tax rate (combined income was below the top of the 12% tax bracket).

If they complete a $75,000 IRA distribution, their AGI will rise to $125,000 and, after taking a standard deduction, their taxable income will be made up of $50,000 of ordinary income ($75,000 IRA minus the standard deduction) and $50,000 of long-term capital gains.

Any income associated with the gains that is above the top of the 12% tax bracket ($81,050 for joint filers in 2021) will be subject to a 15% capital gains tax.

In this example, $20,000 is now subject to $3,000 of tax. The first $55,000 of the IRA distribution was a sound decision; the last $20,000 was significantly more expensive as it exposed $20,000 of the capital gains to taxation. Had they taken no distributions from the IRA, their tax bill would have been $0.

If they took $55,000, their tax bill would have been approximately $3,200. By taking the extra $20,000 they add a total of about $5,400 of tax (12% on the extra $20,000 of ordinary income and 15% on the capital gains now subject to tax). In other words, the tax rate on the additional $20,000 is 27% higher.

While this is not an exhaustive list, the above is meant to illustrate why it is so important to have clients speak with tax advisors about unintended consequences before deciding to convert a Roth, time additional income or sell an asset.

The best-laid plans to manage taxes may be undermined if a client fails to consider how the added income can affect other deductions, tax credits or income-based thresholds.


Razi Hecht, CFP, is vice president of Wealthspire Advisors LLC,  a registered investment advisor and subsidiary company of NFP Corp. He joined the firm in 2015 through the acquisition of Lake Country Wealth Management, which he started in 2014.

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