Social Security and Medicare Tax Traps – What to Look Out For

For many Americans, Social Security and Medicare benefits will be critical to their financial security. However, without proper planning, you could be ensnared by unexpected tax traps that can significantly diminish your benefits.

Beware the Social Security Tax Torpedo

The Problem: The Social Security “tax torpedo” refers to the point at which Social Security benefits become taxable because of income from other sources exceeding a prescribed threshold. The threshold is breached when all sources of provisional income, including income from tax-free bonds and half of Social Security benefits, exceed $34,000 for joint filers or $25,000 for individuals.

When income is between $34,000 and $44,000 for joint filers or $25,000 to $34,000 for single filers, 50 percent of Social Security income is taxable. When income exceeds the upper threshold, 85 percent of Social Security is taxable. When Social Security benefits are included as taxable income, it can also push retirees into a higher tax bracket, further compounding the problem.

A simple example clearly illustrates the impact of tax bracket changes on cash flow and asset depletion. Consider the example of a single taxpayer with a taxable income that puts her in the 22 percent tax bracket. It may appear to her that, for each additional $100 of income, her taxes would only increase by $22. However, if her income exceeds the top Social Security tax threshold, her taxes will increase significantly.

The extra $100 of income becomes $185 when 85 percent of her Social Security benefits are included, and her effective tax rate becomes 46 percent! At that rate, she would have to draw down more income to meet her needs, depleting her assets more quickly. For retirees in higher tax brackets, the effective tax rates could easily exceed 50 percent.

Possible Solutions:

• Convert your taxable retirement income to tax-free income by completing a Roth conversion
• Realize capital losses to lower your adjusted gross income
• Holding lower income-producing funds and securities in a brokerage account.
• Delaying Social Security until age 70
• Setting up Qualified Charitable Distributions to reduce your adjusted gross income post-age 72.

The Medicare IRMMA Cliff

The Problem: As it relates to Medicare, the Income-Related Monthly Adjustment Amount (IRMAA) can impact retirees with higher incomes, and they often don’t see it coming. That’s because Medicare premiums that start at age 65 are based on your Modified Adjusted Gross Income (MAGI) from two years before enrolling in the program. If you land in one of the higher tax brackets during that time, you could pay extra Medicare Part B premiums of more than $4,000.

If your adjusted gross income (AGI) is $97,000 or less for single filers or $194,000 for joint filers, you will pay the baseline Medicare Part B premium of $164.90 per person per month. If your income sneaks above those levels by just one dollar, your premiums will increase. As the table below illustrates, premium increases can be very steep.

The IRMAA assessment is based on a two-year lookback, so your income may fall within the lower brackets, triggering a premium reduction. In the meantime, the IRMAA tax could cost you thousands of dollars. However, it’s possible to mitigate or avoid the tax with proper planning before becoming Medicare eligible.

Possible Solutions:

• Completing a Roth conversion before age 63
• Realizing capital losses to lower AGI
• Funding a high-deductible insurance policy for a Health Savings Account
• Delaying Social Security until age 70
• Setting up Qualified Charitable Distributions to reduce MAGI post-age 72.