5 Retirement Tax Traps You Need to Avoid

Taxes are one of the top three expenses of most retirees, and too many retirees overpay their taxes.Gone are the days when retirement-aged Americans receive tax breaks. Instead, today retirees are likely to face taxes targeted at them.

That’s why tax planning, tax management and especially tax diversification should be important parts of your retirement finances. Tax diversification, as I’ve mentioned in the past, is the key to effective tax minimization in retirement.

You want to have money held in accounts that receive different tax treatment: tax-de-ferred accounts (such as traditional IRAs), tax-free accounts (such as Roth IRAs and health savings accounts) and taxable accounts (also known as after-tax accounts).

When you’re taking distributions from your nest egg during retirement, having the different types of accounts puts in you control. You can manage the distributions and determine the tax rate for the year. (See our April 2018 issue and the August 2020 edition of my Spotlight Series for details.)

You need the trio of tax planning, tax diversification and tax management to avoid the five key retirement tax traps, which I call the Stealth Taxes.

The tax on Social Security benefits is a major Stealth Tax. Social Security benefits used to be tax free, but they have been taxed since the 1980s.This tax affects more and more retirees, because the income levels at which benefits are taxed haven’t been indexed for inflation since 1993. Each year, inflation causes more recipients to have their benefits taxed. Now, about half of beneficiaries pay taxes on their benefits.

Once you hit the income threshold at which benefits are taxed, for each dollar of other income you earn, some of your benefits are included in gross income. The amount included in gross income depends on your income level. That means $1.00 of other income can cause an increase of more than $1.00 in your gross income, and it will be substantially more than $1.00 at some income levels. The marginal tax rate of someone subject to this tax can be 70% or more, depending on state income taxes.

For details about the tax on Social Security benefits, see our February 2019 issue.

The Medicare premium surtax, also known as IRMAA, is a tough one for higher-income retirees.As your income rises, so does your Medicare premium. But this premium surtax is paid separately as part of your income tax instead of as a monthly premium.

There are six income brackets that determine the amount of your Medicare premium surtax. In the highest bracket, the surtax boosts the premium from the standard $144.60 per month (in 2020) to $491.60 per month.

That applies to married couples filing jointly with adjusted gross incomes (AGI) above $750,000 and single taxpayers with AGIs above $500,000. The surtax begins for married couples filing jointly with AGIs above $174,000 and singles with AGIs above $87,000.The trick to the surtax is that your AGI from two years ago determines this year’s surtax. Your 2018 income tax return determines your 2020 surtax, unless you know about and qualify for one of the exceptions.

That’s why you need to pay attention to the level of AGI and the surtax in your tax planning. If you don’t, a little extra income could boost your Medicare premiums in two years by $60, $145 or more each month.

Another Stealth Tax, the net investment income tax (NIIT) was created as part of the Affordable Care Act.The tax can be a bit complicated to compute, but it can be a stiff one on someone with a fair amount of investment income, such as a retiree. You pay a flat 3.8% income tax on the lesser of net investment income or the excess of AGI over $250,000 for a married couple filing jointly or $200,000 for a single taxpayer.

Details are in our August 2012 issue.When you’re in the danger zone for the NIIT, learn about the tax and keep it in mind when planning investment moves.Not many people know about the widow(er)’s penalty, but it’s real and often reduces the after-tax income of surviving spouses.

When both spouses were alive, they filed taxes as married filing jointly. After one spouse passes away, the household income often is close to the same. Sometimes it’s even higher because of life insurance benefits and other factors. But the surviving spouse reports taxes as a single taxpayer after passing the surviving spouse period. That basically doubles the tax bracket. Even if the household income declines a bit, the single taxpayer status can result in a higher tax rate.

Even worse, the same effect can increase the Stealth Taxes, such as the Medicare premium surtax and tax on Social Security benefits.

If you do the math, you’ll find that a surviving spouse taxed as a single taxpayer will owe a higher Medicare premium surtax than the couple paid jointly while both were alive.Whichever spouse survives, the widow(er)’s tax can be hefty when all the taxes are considered. You need to factor this into your retirement plan and in how you decide to structure your income and investment portfolio.You also should consider the heir’s IRA income tax that is imposed by the Setting Every Community Up for Retirement Enhancement (SECURE) Act.

We’ve covered this in detail the last two years. The SECURE Act provides that when an IRA is inherited, the beneficiary must distribute the entire IRA within 10 years, with a few exceptions. This 10-year rule abolishes the Stretch IRA. That accelerates and increases income taxes on beneficiaries. These real-world tax facts are contrary to most people’s views on retirement and taxes.

They believe they’ll receive some tax breaks in retirement and are likely to be in a lower tax bracket. In fact, when you take a hard look at the numbers, you’re likely to be surprised by how high your income tax bill is in retirement. It is not unusual to face higher taxes because of the Stealth Taxes and other factors.

For most people, the situation will become worse as they are forced to take required minimum distributions from traditional IRAs. That’s why it’s important to take the steps I’ve been recommending.Establish tax diversification. You should have some of your nest egg in a Roth IRA or Roth 401(k). You can do this by converting part of a traditional IRA to a Roth IRA.

If you’re still working, shift some of your retirement plan contributions to a Roth 401(k) if one’s available or to a Roth IRA. It often makes sense to start spending down a traditional IRA before you must, while allowing taxable investment accounts and Roth IRAs to compound.

Though deferring taxes for as long as possible is the traditional tax planning advice, it often turns out to be costly by compounding extra taxes during the retirement years, especially the later years.

It is also important to consider the effects of your tax strategies on others, such as a surviving spouse and traditional IRA beneficiaries. You might be leaving them with much less after-tax wealth than you believe.

Take a look at how these Stealth Taxes will affect you and your loved ones over the years. Then, realize you can beat them by converting a traditional IRA to a Roth IRA, emptying an IRA early, converting a traditional IRA to life insurance and more.

For decades, the government encouraged people to put money away for retirement by providing generous tax incentives. Now, the federal government plans to recover those tax breaks, plus interest, as people go through retirement. You can reduce the government’s take by using a long-term view and making a few shrewd moves.