The 5 Big Retirement Tax Ambushes and How to Avoid Them

Taxes are the biggest obstacle to maximizing retirement income and wealth. Most retirees take taxes as a given or don’t give them much thought until near the end of the year or when they prepare their tax returns.

Tax management all year long, however, can reduce out-of-pocket expenses, reduce the financial risks of retirement and increase a family’s after-tax wealth. Begin by identifying the key tax torpedoes that primarily target retirees and can quickly reduce the percentage of your annual income that maintains your retirement standard of living.

The Social Security tax trap steadily diminishes the after-tax Social Security benefits of many middle- and up- per-middle class retirees. The income levels at which the tax is triggered haven’t been adjusted for inflation since 1993. It is estimated that about 80% of Social Security beneficiaries will be hit by the tax within a few years.

Up to 50% of your Social Security benefits are included in the gross income of a married couple filing jointly when their provisional income exceeds $32,000, and up to 85% of benefits are included in gross income when provisional income exceeds $44,000. (The trigger limits are $25,000 and $34,000 for single taxpayers.) More details about this tax are in our February 2019 issue.

Your Medicare premiums for both Part B and Part D increase rapidly once your modified adjusted gross income exceeds the trigger level for the Medicare premium surtax, also known as IRMAA (income-related monthly adjusted amount). The base monthly Medicare Part B premium in 2022 is $170.10.

It rises to $238.10 when your modified adjusted gross income (MAGI) exceeds $91,000 for an individual taxpayer or $182,000 for a married couple filing jointly. There are six premium levels, and the premium tops out at $578.30 when income exceeds $500,000 for individuals and $750,000 for married couples. Details about IRMAA and how to avoid it are in our March 2021 issue.

The net investment income tax (NIIT) takes away an additional 3.8% of net investment income when modified adjusted gross income exceeds $200,000 for individuals and $250,000 for married couples. See the December 2020 issue for details.

Then there’s the survivor’s penalty, or widow’s penalty. After one spouse passes away, the survivor’s tax filing status moves from married filing jointly to individual. This substantially increases the federal income tax bill on the same income.

Even when income declines some (because one Social Security check and perhaps some other income will end), the tax bill will be higher because of the change in filing status. Details are in our November 2020 issue. Finally, there’s the income tax burden on large traditional IRAs and 401(k)s under the Setting Every Community Up for Retirement Enhancement (SECURE) Act enacted in 2019. Technically, this is a tax on the beneficiaries who inherit the IRA.

They must distribute it within 10 years instead of being able to spread the distributions over a longer period. That increases their income taxes and reduces the after-tax wealth they inherit. As an alternative, there are several ways the owner of a traditional IRA can reduce the tax burden on beneficiaries and increase their after-tax inheritances. But doing so might increase the lifetime income taxes paid by the account owner. Details are in our March and April 2020 issues. I refer to these taxes and others collectively as the Stealth Taxes.

These taxes that target retirees explode the myth that you’re likely to pay a lower tax rate in retirement than during your working years. And remember that the 2017 income tax rate cuts are scheduled to expire after 2025. That’s why in retirement, tax planning should be more aggressive and done more frequently than during your working years.

There are five strategies you need to coordinate to reduce the income tax burden on your retirement income and assets. Establish tax diversification. Your retirement funds can be in different types of accounts, and they will be taxed differently.

You’ll have more flexibility and can reduce taxes more effectively when your retirement money is diversified across these different types of accounts. You should have tax-deferred accounts (traditional IRAs and 401(k)s and deferred annuities), tax-free accounts (Roth IRAs and health savings accounts) and taxable accounts (regular brokerage and mutual fund accounts).

If that means converting part of a traditional IRA or 401(k) to a Roth IRA, carefully consider doing that. Use tax-wise asset location. Investments that generate ordinary interest and dividends should be in tax-deferred accounts. This lets the income compound to a higher amount before it is taxed. These assets include most types of bonds, certificates of deposit (CDs) and the like.

Assets with their own tax advantages should be in taxable accounts. These include long-term capital gain assets and those that pay qualified dividends as well as tax-free assets, such as tax-exempt bonds.

Ideally, assets with your highest returns should be in Roth IRAs to maximize tax-free income. Otherwise, any asset without its own tax preferences can be in a Roth IRA. You might not be able to allocate assets exactly like this, but strive to be as close as practical.

Use tax-wise distributions. Through- out the year, coordinate distributions from the accounts to minimize income taxes. You might have required distributions from traditional IRAs and 401(k) s. You also might have Social Security benefits, interest and dividends earned in taxable accounts, and other income over which you have no control. After that, pay attention to your estimated income tax bracket for the year.

When you have relatively low income or a higher-than-usual level of deductions, you might want to take additional distributions needed to meet your expenses from traditional IRAs. In years of higher income or lower deductions, you might want to fund extra spending with distributions from tax-free accounts. It takes more work to minimize income taxes in retirement.

I’ve seen estimates that taking these steps can increase after-tax retirement income by up to 33%. That’s probably worth all the work.