Reducing Medicare Premiums, Social Security Taxes and More

Retirees face the highest marginal tax rates. They use the same tax tables as everyone else, but there are nuances in the tax code that can trigger higher marginal rates for seniors. For retirees in what I call the marginal rate trap zone, reducing gross income or taxable in-come can have powerful benefits.

The marginal tax rate is the rate on the last additional dollar of income. For example, if you’re at the top of the 25% tax bracket and your next dollar of income pushes you into the 35% bracket, your marginal rate is 35%.

Marginal rates are high for seniors because each additional dollar of income can trigger additional taxes or surtaxes or reduce tax benefits.

Higher Medicare premiums, called a surtax, are owed on both Part B and Part D as adjusted gross income rises. There’s a lag with the Medicare surtax. Your 2011 tax return determines your 2013 Medicare premiums. Your 2012 income tax return will determine your 2014 Medicare premiums. The table nearby shows the premiums and surtaxes for 2013.

Social Security is taxed as income rises, with up to 85% of Social Security included in gross income when AGI is above $44,000.

Another trap is that itemized deductions and personal exemptions are phased out as income rises. Earn too much and you’ll not only be taxed on that income but you’ll lose deductions, effectively taxing income that wasn’t taxed before. These phaseouts were suspended the last few years but will take effect in 2013 if Congress doesn’t take action. (It might make a deal after this issue was completed or early in 2013.) There are a number of other tax breaks that are phased out at various income levels.

That’s why income tax planning is more important and more complicated for retirees.

Increasing itemized expense deductions won’t help you beat any of these taxes. The additional taxes are triggered by higher gross income or adjusted gross income (AGI). You won’t reduce them by increasing deductions for mortgage interest, real estate and personal property taxes, charitable contributions, medical expenses, and miscellaneous expenses.

When your AGI is near one or more of the phase-out ranges, it can make sense for you to adjust activities to reduce AGI. (AGI is the last line on the first page of Form 1040.) For most of the phaseouts, modified AGI is used. This is regular AGI increased by tax-exempt interest, EE savings bond interest, and the foreign earned income exclusion, though the details of MAGI can vary between the different tax breaks.

Here are some strategies that can help reduce MAGI and cut the Medicare surtax and other extra taxes.

A few strategies can help you reduce or eliminate the Medicare surtax.

– Limit withdrawals from retirement plans and annuities to only the amounts needed for spending and required by law or contract. Avoid selling assets that would increase capital gains in taxable accounts, except to the extent you need the cash to meet your spending needs.

Naturally you don’t want to avoid selling assets that should be sold under your portfolio strategy just to avoid paying a tax. If an asset is highly valued, it could lose 20% or more quickly, and that loss likely would be more than the extra taxes triggered by taking the gain. But when considering a sale, keep in mind that higher taxes could be triggered by the sale and factor that into your decision.

– Take capital losses by selling assets with paper losses. Capital losses shelter all capital gains dollar for dollar. Up to $3,000 of additional capital losses can be deducted and offset other income, and any capital losses in excess of that can be carried forward to future years and used the same way.

– Losses from businesses also reduce MAGI. Losses can come from a sole proprietorship, partnership, limited liability company, or subchapter S corporation. You might be able to turn a hobby into a business. You have to run the activity like a real business, not a hobby, to meet the IRS’s rules for deducting losses.

– Losses from rental real estate also reduce MAGI when you quality as actively involved under IRS regs so that they are not passive losses. That’s not a good reason by itself to acquire a rental property and enter the rental real estate business. But if you were thinking about it anyway, it can be one more factor in its favor.

– A number of deductions also reduce MAGI, though they don’t all apply to seniors and retirees. Among the most common are health savings account contributions, self-employment taxes, contributions to self-employed retirement plans, and self-employed health insurance premiums.

There might be an additional opportunity to reduce or avoid the Medicare surtax. An appeal can be filed when your financial situation has changed for the worse since the tax return was filed.

The most common reason for a successful appeal is a change in marital status, such as marriage, divorce, or widowhood. You’ll need to establish that the change resulted in a lower MAGI.

Other reasons for successful appeals are retirement, not working for other reasons, and a reduction in working hours by you or your spouse. It doesn’t matter if the changes were voluntary or involuntary. All that matters is that one of the named changed occurred and reduced your MAGI now is below what was reported for two years earlier and that it was caused by one of these events.

When you filed an amended tax return after the IRS already sent the original return data to Social Security to determine the Medicare surtax, you can file an appeal using the amended return data.

You won’t be able to appeal successfully when there was a one-time increase in your income two years ago. Your income might have surged due to a large capital gain, distribution from a retirement account, or a conversion of a traditional IRA to a Roth IRA. Each of these will increase your MAGI for the year, and that will increase your Medicare surtax and perhaps other taxes for one year. When your income returns to normal, so will the taxes and Medicare premiums.

RW January 2013.