Retirees and near-retirees need to worry more about Stealth Taxes than regular income taxes.
Stealth Taxes include the amount of Social Security benefits added to gross income, the Medicare premium surtax (also known as IRMAA), the 3.8% net investment income tax and more.
Some Stealth Taxes are directed specifically at retirees, such as the tax on Social Security benefits and the Medicare premium surtax. Others just happen to catch more retirees than other taxpayers.
I call them Stealth Taxes because they increase income taxes without Congress enacting a tax rate increase. Instead, gross income is increased or an additional amount is added to regular income taxes.
The key to the Stealth Taxes is adjusted gross income (AGI), because that is the starting point for computing most of the Stealth Taxes.
AGI is on line 11 of the current 1040. Most of the Stealth Taxes require that some tax breaks be added to AGI to compute what is called modified AGI or MAGI. For most people, computing MAGI involves only adding any tax-exempt interest to AGI.
Some people might have to add other items, such as tax-exempt foreign-earned income, and some of the Stealth Taxes have small differences in their computation of MAGI. But for most people, MAGI is the same as their AGI or is AGI plus tax-exempt interest.
Most Stealth Taxes are computed using that year’s MAGI. But the Medicare premium surtax is determined using MAGI from two years earlier.
Before putting away your 2022 income tax return, make a note of your AGI and see if it triggers any of the Stealth Taxes or if you are in a high Stealth Tax bracket (especially for the Medicare premium surtax). Then, consider actions you can take the rest of this year to reduce your 2023 AGI.
The first step is to add all the income this year that is mandatory or over which you have no control. This income includes taxable Social Security benefits, any pension, required minimum distributions from IRAs and other retirement accounts, annuity payouts, interest and dividends from taxable account holdings and perhaps other sources.
The total is a good estimate of your base or minimum AGI for 2023.
The second step is to determine how close your base AGI is to triggering the Stealth Taxes or to the beginning or ending of a Stealth Tax bracket.
For example, the Medicare premium surtax has six brackets. The monthly surtax in 2023 varies from $66 to $362, depending on the bracket you’re in.
The third step is to estimate the money you are likely to spend this year and determine the amount by which the spending exceeds your base AGI.
The fourth step is to decide the sources of the cash for the additional spending by considering the effect of the sources on your income taxes and your Stealth Taxes.
When you’re close to triggering a Stealth Tax or being pushed into the next higher bracket, consider taking the cash from tax-free sources, such as distributions from Roth IRAs or health savings accounts.
Or you might want to sell investments in taxable accounts that will generate tax losses or small capital gains.
When additional taxable income won’t trigger or increase the Stealth Taxes, you might want to take the cash from taxable sources, such as distributions from traditional IRAs or 401(k) s.
That reduces the future income from those taxable sources and saves tax-free and low-tax sources for years when you might need them to avoid Stealth Taxes.
Finally, you want to consider how to avoid the Stealth Taxes in the future. The best strategies involve taking money out of traditional retirement accounts and paying the taxes today to reduce future ordinary income.