Beware of the Tax Traps in Retirement

More people are going to retire in the next 15 years than have ever retired in the history of our country. By 2030, the Census Bureau projects we’ll reach the first time that the United States will have more 65-and-older adults than children — 78 million age 65+ versus 76.4 million younger than 18.

Meanwhile, our spiraling national debt and its effect on taxpayers can’t be ignored. Consider that prior to COVID, the United States was already over $22 trillion in debt. Accelerated by the $2.2 trillion CARES Act passed in March 2020 and the $1.9 trillion coronavirus relief bill in March 2021, our national debt now stands at over $28 trillion. At some point, it’s more than likely taxes are going to increase to pay for all of the spending and borrowing.

At the same time, more than $30 trillion is sitting in retirement accounts right now that must be withdrawn. As you plan for retirement, it’s vital to keep in mind that the government has numerous ways to tax you, and that it can move the goalposts. That could be a significant problem if you are unprepared.

These are the three tax traps that could ensnare the unaware:

Tax trap No. 1: The RMD

The required minimum distribution, or RMD, works like this: Starting at age 72, you must make taxable withdrawals from your retirement accounts, and if you miss your RMD, the government can impose a tax penalty of 50% of the amount you should have withdrawn. That’s 50% in addition to your income tax rate.

Tax-deferred retirement accounts subject to RMDs include traditional IRAs, 401(k)s, 403(b)s and any other type of tax-deferred account. The IRS mandates a withdrawal percentage that increases every year as you age. These withdrawals are all taxable at your ordinary tax rate, and they can trigger additional taxes on your government benefits as well, such as Social Security and Medicare.

Tax trap No. 2: Social Security and provisional income

Social Security is a tax-free benefit until you hit certain income levels. Then it becomes taxable.  Provisional income is the IRS threshold above which Social Security income is taxable. In the IRS equation, they consider any taxable income, so that means interest, dividends, capital gains and, if you’re still working, wages.

They take any tax-deferred income as well. And finally, they take any tax-free interest plus half of your annual Social Security benefit amount.

For example: A married couple receive $40,000 in Social Security. Half of that – $20,000 – is used for the IRS equation. They add up all those other forms of income, plus the $20,000 from Social Security, and if the total comes to more than $44,000 for a married couple ($34,000 for a single filer), then up to 85% of their Social Security is now taxable. But if you’re married and keep that number below $32,000, none of your Social Security is taxable.

By minimizing or eliminating provisional income, you keep more of your money for your future financial security.

Tax trap No. 3: Medicare

Just like with Social Security, Medicare has a surprise for you. The income-related monthly adjustment amount (IRMAA), an arcane term that many have never heard of, acts like an additional tax based on your income that is added to your Medicare premiums. It’s not just the wealthy who are getting affected by this; it’s anyone who has done a good job of saving throughout their working lives.  For a couple, the IRMAA surcharges can add up to over $10,000 per year to your Medicare premiums per year. 

Strategies and tactical steps

Here are some options to consider that can help you prepare for and avoid these tax traps:

A Roth IRA

A traditional IRA allows you to deduct your contributions from your current income, grows tax-deferred and is taxed when you make withdrawals, such as RMDs. Contributions to Roth IRAs, however, are made using after-tax money, but the special sauce is that the growth and the withdrawals are tax-free. And there are no RMDs.

There are two ways to deposit money into Roth IRAs:

1. Make contributions each year (see your adviser about limits).
2. Convert a traditional IRA to a Roth. This is a powerful tool to use to avoid RMDs, provisional income and IRMAA.

A Roth IRA conversion is a process where you move money from a traditional IRA that has not been taxed into a Roth IRA that grows tax-free and from which you can withdraw funds tax-free. When you convert the IRA funds, you pay taxes on the amount you convert. And you must keep the converted funds in your Roth for at least five years.

You can choose to convert the entire amount or, if you are worried about being pushed into a higher tax bracket, you can convert a little each year. It’s important to consult your adviser or CPA before you make a conversion to make sure you understand all the tax implications.

A careful Social Security timing strategy

In the context of taxes, the focus is on coordinating the timing of the age that you take your Social Security with the long-term goal of avoiding provisional income.   For example, if you are converting a traditional IRA to a Roth IRA, it may be smart to delay taking your Social Security until you are finished making the conversion.  This can help you avoid a higher provisional income during the conversion.

A Qualified Charitable Distribution

This is a direct transfer of funds from your traditional IRA, payable to a qualified charity. QCDs can be counted toward satisfying your RMDs for the year, as long as certain rules are met.

In addition to the benefits of giving to charity, a QCD excludes the amount donated from your taxable income. Keeping your taxable income lower may reduce the impact to certain tax credits and deductions, including Social Security and Medicare.

However you proceed, it’s important for you to have a strategy in place, with specific steps to take each year, to minimize your taxes as you move toward and into retirement.

Dan Dunkin contributed to this article.