When people in their 40s and 50s think about retirement they often picture the “Golden Years,” where life is all play and no work. And while retirement should be a season of rest and enjoyment, adjusting to a fixed income or wondering if you’ve saved enough can cause stress – especially when there are also hidden “tax traps” that could trigger costs you haven’t accounted for. These unknowns can quickly tarnish your feelings of peace with foreboding. But we’re here to help.
In this blog, we’re breaking down the most common tax traps that pop up in retirement with strategies to help you avoid them – so you can feel confident your long-term plan is ready for the long haul.
Understanding the most common tax traps in retirement
A “tax trap” happens when a withdrawal or infusion of extra income unintentionally pushes you into a higher tax bracket, triggering unexpected taxes or costs. For retirees, the most common tax traps are associated with Social Security benefits, Medicare costs, or retirement accounts. Over time if left unchecked, these tax traps can have a domino effect, significantly reducing your income, increasing expenses, and impacting your financial stability and retirement plan.
Most retirement tax traps are triggered by three things:
- Income thresholds. Crossing over a particular dollar amount can bump you into a higher bracket making more of your income taxable or increase costs, such as with Medicare premiums.
- Phaseouts. These gradually reduce credits, deductions, or benefits as your income increases (raising your marginal tax rate).
- Benefit reductions. Earning more income can affect your eligibility for government benefits, like Social Security, causing it to be partially withheld or lost entirely.
When these tax traps are triggered during working years, most people can simply adjust their budget or earn more to offset the increased costs, but it’s much more difficult for retirees who have less financial flexibility. This is why it’s imperative to work with a financial expert to help you strategically and proactively coordinate your withdrawals, Social Security, and investment income. Better planning on the front end provides greater security later.
Identify + avoid tax traps: Social Security
Social Security is already one of the biggest sources of tax confusion for retirees – and when you add on the risk of unwittingly triggering extra taxation, it can get overwhelming fast. Here’s are two things to know:
- Provisional income: The IRS uses a formula called provisional income to determine how much of your Social Security is taxable. It calculates your total based on all taxable income, tax-exempt interest, and half of your Social Security benefits.
- Thresholds: These are benchmarks that determine when Social Security benefits become taxable. For instance, if your provisional income exceeds $25,000 for a single person, or $32,000 if you’re married and filing jointly, up to 50% of your Social Security may be taxable. If it exceeds $34,000 (single) or $44,000 (couple), the taxable amount increases to 85%.
Here’s a scenario to consider: Let’s say a retiree withdraws just $5,000 from their IRA to cover a vacation, but that amount happens to bump their provisional income above a particular threshold…more of their Social Security will become taxable, resulting in a much larger bill than they anticipated.
3 ways to avoid the trap:
- Time your withdrawals. Be strategic about when you take a withdrawal so you ensure you’re remaining under a threshold.
- Consider Roth conversions. Think this through before retirement, so withdrawals later won’t count as taxable income.
- Smooth your income. Spread distributions across multiple years instead of one large sum.
Identify and avoid tax traps: Medicare-related
Just like we covered in our bullets about Social Security, thresholds really matter for Medicare too – but particularly when it comes to these two acronyms: IRMAA and MAGI.
MAGI stands for Modified Adjusted Gross Income. It represents your adjusted gross income with a few specific tax deductions added back. The IRS uses it to determine your eligibility for certain tax benefits like credits and deductions. Individuals and married couples whose MAGI exceeds certain higher levels are subject to IRMAA (Income-Related Monthly Adjustment Amount), a surcharge on their Medicare Part B and Part D premiums.
Currently, the first surcharge for an individual begins when their MAGI exceeds $103,000. For couples filing jointly, it doubles to $206,000, and rises several tiers after that. MAGI can be increased in a variety of ways when a circumstance bumps you into a higher tax bracket. This could include a one-time event (like selling a property) or taking a large one-time distribution, but can potentially cost you thousands more in premiums annually.
The best way to avoid these tax traps are by managing your MAGI and spreading income over multiple years. Here are 3 strategies to reduce your risk:
- Coordinate withdrawals across different account types.
- Spread large transactions (like Roth conversions or property sales) across multiple years – preferably lower income ones.
- Explore charitable giving. There are loads of creative, tax-smart ways you can give donations that will not only bless an organization you care about, but also reduce your taxable income.
The Domino Effect
We mentioned earlier that tax traps can pile on one another like dominoes if they’re not handled correctly. Now that these traps are on your radar, here’s a picture of how that would look:
Let’s say you take a large withdrawal from your IRA. This withdrawal:
- Increases your provisional income, which makes more of your Social Security taxable
- Raises your MAGI, potentially triggering higher Medicare premiums, too.
The truth is every income decision you make has ripple effects. The good news is that taking action early to consider your retirement holistically can help you avoid tipping even the first tile. You don’t have to live worrying when the other shoe will drop.
Our team at Cornerstone Financial is committed to helping you design a financial plan that not only provides for you and your loved ones, but also aligns with your values.
Proactive tax planning before and during retirement can help you build in margin, prepare for the unexpected, and employ wise strategies to help you make the most of your investments and savings. As Proverbs 24:14 says, “Know also that wisdom is like honey for you: If you find it, there is a future hope for you, and your hope will not be cut off.”
Let’s tax-trap-proof your plan together. Contact us today.
The mission of Cornerstone Financial Advisory is to be an engine of blessing to our clients, families, and community. Our method of accomplishing our mission is by practicing servant leadership.
We will serve and create compelling value for our clients by leading and inspiring clients to reach their goals. With their permission, we will hold clients accountable on keeping their best intentions. We, in turn, translate our client’s needs, goals, and values into a strategy, helping align their actions with their values.
