February 28

Prepare for 5 Tax Traps in Retirement

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As seen in the Bradenton Herald – March 2nd, 2021

For us working stiffs, federal income taxes are generally straightforward, because our income is primarily derived from a paycheck. However, taxes in retirement, can become much more complicated because your income may come from multiple sources and each of these sources may have different taxation.  The following are 5 traps that can be very costly to your wallet.

Tax Torpedo

This is a name given to the unexpected way that Social Security can get taxed, depending on how much other income you have.  It occurs when an income source such as an IRA distribution inadvertently causes more Social Security benefits to be taxable and increase the marginal tax rate of the transaction.  In certain cases a couple in the 25% tax bracket could see that additional income taxed at 46.25%.  Because the income amounts that are subject to tax aren’t indexed for inflation, more and more retirees will be ensnared in the tax torpedo in coming years.

IRMAA

Medicare has a series of income limits that trigger increasingly higher payments for retirees. IRMAA stands for income-related monthly adjusted amount. The more income you distribute in retirement the more you pay for Part B & Pard D Coverage.  The sliding scale increases the premium amount the participant must pay and ranges from 35% of the cost up to 80%.  While it may not always be feasible to plan your income to avoid IRMAA, one important thing to consider is that even exceeding the threshold by $1 causes you to pay the next higher premium level. The worst part is that crossing a threshold at the end of year increases your premium retroactively to the beginning of the year.

NII

This refers to the 3.8% surcharge – net investment income tax – sometimes referred to as the “Obamacare” tax.  Once your adjusted gross income exceeds either $200,000 single or $250,000 married, your investment income is subject to the additional tax. The income threshold is not indexed for inflation and stays at this level every year. The tax is applied on the lesser of the actual investment income or the amount your income exceeds the threshold.

Widows Penalty

The widow’s penalty is an unwelcome surprise to a surviving spouse who has a higher tax liability even though they may have less income. Tax brackets benefit those that are married versus those that are single. Many times, widows will be receiving less income – reduced social security at a minimum – but will be pushed up to higher tax brackets when they file. In addition to higher tax rates, widows lose half the standard deduction as a single filer, driving their tax bill higher.  In many circumstances the widow could also be liable for all the before mentioned traps as well.

Children’s Penalty

Before the Secure Act was enacted in December of 2019, those who inherited IRAs could stretch out the withdrawals and required tax payments on each distribution over their life expectancy. Now, for retirement account owners who pass away, non-spouse beneficiaries with some exceptions, will be required to withdraw assets in an inherited IRA within 10 years.  The withdrawals will be subject to taxes and likely will impact children during their peak earning years significantly increasing their tax liabilities.

Unfortunately, many retirees are shocked to find out just how much of their income is subject to taxes.  Without a comprehensive tax strategy in place, many retirees may pay up to 3x more in taxes than needed to. The distribution phase of withdrawing money from your savings is a lot more complicated than the accumulation phase and tax planning is just one reminder of how true this is.  An optimal retirement plan utilizes tax savings strategies to maximize retirement income and ensures that you are paying your fair share of taxes but not leaving a tip.

Gardner Sherrill, CFP, MBA, is a CERTIFIED FINANCIAL PLANNERTM with Sherrill Wealth Management. To learn more visit sherrillwealth.com, a Bradenton wealth management firm specialized on living in retirement.

This information is not intended to be a substitute for specific individualized tax or legal advice. Individual circumstances will vary. Please see your tax professional regarding your specific situation.

The opinions expressed in this material are not intended to provide specific advice or recommendations for any individual.

Securities and advisory services offered through LPL Financial a registered investment advisor. Member FINRA/SIPC.


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About the author

Gardner is a CERTIFIED FINANCIAL PLANNER and principal of Sherrill Wealth Management in Bradenton, Florida. He has spent 20+ years in the wealth management field helping families negotiate the various obstacles and opportunities that retirement provides them. Read More

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