Many people assume they will pay less in taxes in retirement than in their working years since they will no longer be earning a paycheck. However, for many Americans, that is not the case. Some individuals end up paying more taxes in retirement, especially if they have not planned out a strategy for minimizing them. In addition, from today’s historically low tax rates and brackets, it is likely that we will see higher tax rates in the future, given the country’s rapidly aging population and terrible debt problems.
This can turn into a major problem if you do not account for taxes in your retirement planning. Suddenly, you could find yourself with significantly less income than you thought you would have. You can avoid this scenario by creating a tax strategy and understanding some of the tax traps in retirement. If you understand how people get stuck paying more taxes, you can make moves to avoid it. Read on to learn some unexpected taxes you may face in retirement.
1. Social Security taxes
While you are working, you pay into Social Security. Once you retire, these payments create a sort of pension that you can depend upon throughout retirement. Many people assume that they do not pay taxes on Social Security since this money came from their prior taxes, but this is not the case.
The taxes you pay on Social Security depend on your level of “provisional income”, which includes most sources of income except for Roth IRAs and life insurance. Unfortunately, taking distributions from a retirement account like an IRA can actually trigger additional Social Security taxes. Moreover, both the tax rate and the percent of your taxable Social Security income increase with additional income. The income amounts subject to tax are not indexed for inflation, so this will become a more significant issue later on as you need to take out more money to maintain purchasing power. Using today’s historically low tax rates to shift money into the forever tax free world of the ROTH IRA, through ROTH Conversions, can help reduce or even eliminate the taxes on your Social Security. Always think about how your income could affect Social Security payments before making financial decisions.
2. Net investment income tax
If you have an adjusted gross income greater than $200,000 for an individual or $250,000 for a couple, an additional tax gets applied to your investment income. This tax is a flat 3.8 percent surcharge that sometimes gets called the Obamacare tax. As with the Social Security tax thresholds, this does not get indexed for inflation. Therefore, more people will likely pay the tax in upcoming years as they have greater income due to inflation. You will need to pay the tax on the actual investment income or the amount that your income exceeds the applicable threshold, whichever of the two is the lesser.
3. Children’s penalty
The Secure Act, which was enacted in December 2019, changed the rules related to the inheritance of an IRA. Before this date, people who inherit the account were able to stretch out their withdrawals and thus the required tax payments on each distribution over the rest of their life expectancy. Now, however, individuals who inherit an IRA will need to withdraw all the assets within 10 years. This rule does not apply to spouses and does have a few exceptions, but the vast majority of people who inherit the account will be forced to liquidate the account within a decade. While this does not affect your tax liability, it could significantly increase taxes for your children and can be avoided by passing assets in a different manner, such as converting your IRAs to ROTH IRAs over time. Your estate planning process should take into account taxes due even after you have passed.
4. Widow’s penalty
Even surviving spouses can be hit with unexpected taxes. They may end up with a higher tax liability even though overall income is likely reduced. Tax brackets are designed to benefit couples rather than single people. For that reason, surviving spouses are often in a higher tax bracket than they were when married even though they likely have less money coming in since, at a minimum, Social Security will be reduced.
Also, surviving spouses lose half of the standard deduction they previously got once they are a single filer, which may also increase their tax bill. Therefore, it is important to think about the financial situation of either spouse should the other pass and make sure that the situation is tenable. Some strategies may be available for lowering tax liability.
5. Income-related monthly adjusted amount
All retirees depend on Medicare for at least some of their healthcare needs. The Medicare program has several different income limits that will trigger higher monthly premiums for retirees. Income-related monthly adjusted amount (IRMAA) is the increased payment you will face for Part B and Part D coverage based on the amount of money you have coming in each month. The sliding scale ranges from 35 percent to 80 percent of the total cost of insurance. You will not always be able to plan your income around IRMAA, but it is an important tax to keep in mind. Exceeding the threshold by even a single dollar will push you to the next higher premium, and that new percentage applies retroactively to the entire year. You should be particularly mindful of these thresholds as get closer to the year’s end.