The goal of retirement income planning is to optimize the longevity of your after-tax retirement income to pay for your projected inflation-adjusted expenses. In addition to having adequate retirement assets, there are two ways to achieve this goal: (a) maximize income and (b) minimize income tax liability.
There are six stealth taxes that can increase your income tax liability and reduce your lifetime after-tax retirement income. All of them, except for one, have been in existence for several years. A couple are difficult to avoid due to their low-income thresholds. Although several taxes may not kick in until retirement, planning for each of them should begin long before and continue throughout retirement.
Stealth Tax #1: 10-Year Payout Rule
Let’s start with the new kid on the block – the 10-year payout rule. This was created by the SECURE Act and is generally effective for deaths after December 31, 2019. It applies to beneficiaries of retirement plans and IRA accounts.
Surviving spouses, minor children who are not grandchildren, and other “eligible designated beneficiaries” are unaffected by the 10-year payout rule. They can continue to take distributions from retirement plans and IRA accounts over their lifetime using the required minimum distribution, or RMD, rules.
Children after reaching the age of majority and grandchildren are classified as “non-eligible designated beneficiaries.” They are no longer required to take RMDs from their retirement and IRA accounts. They are instead subject to the new 10-year payout rule whereby they must empty these accounts by the end of the tenth year after death.
Distributions can be taken evenly over ten years or in random years so long as there’s no balance remaining in any retirement or IRA accounts by the end of the tenth year after death of the individual from whom you inherited the accounts.
Two potential types of stealth taxes have been created by the 10-year payout rule. The first type comes in the form of accelerated and potentially increased income tax liability compared to the RMD rules. The second type is a potential penalty assessed by IRS as an “additional tax on excess accumulations” of 50% plus interest on the balance of funds remaining in any retirement plan or IRA accounts at the end of the tenth year.
Stealth Tax #2: Social Security
Taxation of Social Security benefits, which began in 1984, is one of the stealth taxes that is difficult to avoid due to its low-income threshold. The threshold, which is referred to as “combined income,” is the total of adjusted gross income, nontaxable interest, and half of your Social Security benefits.
Single individuals with combined income of $25,000 to $34,000 are taxed on up to 50% of benefits, and up to 85% on amounts above $34,000. Joint return filers with combined income of $32,000 to $44,000 are taxed on up to 50% of benefits, and up to 85% on amounts exceeding $44,000. Unlike other income-sensitive thresholds, Social Security combined income amounts have never been increased for inflation.
Taxation of Social Security benefits is often a double stealth tax. The inclusion of up to 85% of benefits in taxable income, in addition to potentially increasing tax liability, can also increase marginal and long-term capital gains tax rates. Other potential fallouts include increased Medicare Part B and D premiums, increased exposure to net investment income tax, and increased widow/widower’s income tax.
Stealth Tax #3: Increased Medicare Part B and D Premiums
Medicare Part B and D premiums are determined using modified adjusted gross income (MAGI) from your federal income tax return two years prior to the current year. Assuming you enroll in Medicare at age 65, you will want to project and track your MAGI every year beginning at age 63.
Monthly premiums begin at $148.50. An Income Related Monthly Adjustment Amount (IRMAA) is added to this amount if your income is greater than $88,000 for single taxpayers and $176,000 for joint tax filers. Monthly premiums can be as high as $504.90 for those in the top income threshold, resulting in increased annual Medicare premiums of as much as $4,276.80 per person or $8,553.60 per couple.
Medicare Part B and Part D monthly premiums can increase significantly in a particular year because of an unusually large amount of income two years prior to the current year. This can include taxable gains from the sale of a residence or rental property or income from a sizable Roth IRA conversion.
Stealth Tax #4: Net Investment Income Tax
The net investment income tax has gone under the radar for a lot of taxpayers since its introduction in 2013. The tax is a surtax that is generally paid by high income taxpayers with significant investment income.
Single taxpayers with investment income and MAGI greater than $200,000 and married filing joint taxpayers with MAGI more than $250,000 are subject to a surtax of 3.8% on net investment income. This includes capital gains, interest, dividends, rental income, royalties, and nonqualified annuity income.
The net investment income tax effectively increases the 15% and 20% long-term capital gains tax rate by 3.8% for higher income taxpayers.
Stealth Tax #5: Widow(er)’s Income Tax Penalty
Stealth tax #5, the widow(er)’s income tax, is the stealthiest of all stealth taxes since most people aren’t aware of it, it’s the most difficult to plan for, and it can potentially increase tax liability significantly each year going forward once it applies.
Unfortunately, the income tax law is not kind to surviving spouses who don’t remarry. A widow or widower who has the same, or even less, income than the couple enjoyed will often be subject to higher federal, and potentially, state, income tax liability. This results from the transition from the use of married filing joint tax rates to single tax rates and a standard deduction of 50% of the married filing joint amount of $25,100, or $12,550, beginning in the year following the year of death of one’s spouse.
Stealth Tax #6: $10,000 Limitation on Personal Income Tax Deductions
Unlike the first five stealth taxes that directly increase income tax or Medicare premiums in the case of stealth tax #3, stealth tax #6 indirectly achieves the same result. The $10,000 limitation on the personal income tax deduction accomplishes this by eliminating a potentially large amount of one’s overall tax deductions for those affected by it. This has translated to reduced itemized deductions of tens of thousands of dollars or more in many cases since 2018.
This change, combined with the doubling of the standard deduction and reduced mortgage interest deductions, has reduced the percentage of taxpayers itemizing their deductions from approximately 31% in 2017 prior to the enactment of the Tax Cuts and Jobs Act to approximately 14% in 2019.
Stealth Tax Planning Opportunity: Staged Roth IRA Conversions
Although there are various retirement income planning strategies that can be implemented to address each of the six stealth taxes discussed in this article, there is one strategy that can reduce income tax liability attributable to the first five. The strategy to which I am referring and have espoused for many years, is a staged, or multi-year Roth IRA conversion plan.
The current low historic income tax rates that will expire after 2025 and potentially sooner provide a window of opportunity for Roth IRA conversions that many of us may never see again in our lifetime. If you’re in your 50’s or 60’s and you have traditional 401(k) plans, SEP-IRAs, and traditional IRAs, why wait until age 72 when the value of your plans has potentially doubled, and tax rates are potentially higher to pay income tax on your distributions?
When you do a Roth IRA conversion, or a series of Roth IRA conversions using a staged Roth IRA conversion plan, you eliminate taxation on the future growth of converted assets, reduce required minimum distributions (RMDs) beginning at age 72, and reduce dependency on taxable assets in retirement. This, in turn, allows you to reduce your exposure to the first five stealth taxes throughout your retirement years as follows:
- Reduce the value of taxable assets impacted by the 10-year payout rule
- Decrease the Social Security “combined income” threshold, potentially decreasing your percentage of taxable Social Security benefits
- Decrease modified adjusted gross income (MAGI) which can potentially reduce your Medicare Part B and D premiums beginning at age 65
- Potentially decrease your net investment income tax since this is calculated using MAGI
- Reduce the value of taxable retirement assets and your exposure to the widow(er)’s income tax liability if you’re married
Look Beyond Current Income Tax Rates When Planning for Retirement
The six stealth taxes discussed in this article can impact the success of your retirement in various stages of your life beginning long before you retire and continuing throughout your retirement. It behooves you to not get lulled into a false sense of security by today’s low federal income tax rates since they are scheduled to sunset after 2025 and this may occur sooner. While it is difficult, if not impossible, to predict future rates, it is better to err on the conservative side when planning for a long-term event like retirement that may not begin for many years.
Furthermore, it is crucial to look beyond rates to understand how stealth taxes can potentially derail your retirement. None of them is likely to be eliminated since each is responsible for billions of dollars of annual tax revenue. On the contrary, additional stealth taxes will be imposed as part of future tax legislation based on historical precedent. This is likely given the out-of-control federal deficit and the fact that stealth taxes are confusing and often fly under the radar – hence their name.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.