Watch Out for “Tax Torpedoes”
Our tax laws include several tax triggers that are activated once certain income levels are reached. This tax concept is part of the progressivity in our tax structure, where ability to pay is an important consideration for lawmakers. Just as marginal tax rates increase the higher up the income scale you are, there are additional taxes lurking at certain income levels that result in even higher marginal tax rates.
Social Security Benefit Taxation
Perhaps the most common income-related tax involves Social Security benefits. If most or all of a taxpayer’s income is from Social Security benefits, it is likely that none of them will be taxed. However, as non-Social Security income increases, an increasing percentage of one’s Social Security income is taxed. This is sometimes referred to as the “tax torpedo”. There is a somewhat complicated formula for determining the amount of Social Security income, which few people actually see unless they are still doing their taxes on paper and must complete the worksheet in the instruction booklet. But to summarize, if provisional income (half of one’s Social Security benefits plus additional income, including tax-free income) exceeds $25,000 for single filers or $32,000 for joint filers then at least some portion will be taxable. That percentage will increase up to a maximum of 85% of the benefits being taxable when provisional income reaches $34,000 single or $44,000 joint. In time, more and more people will reach the 85% maximum, because the income levels in the formula are not adjusted for inflation, unlike the income levels for marginal tax rates.
Prior to 1984, Social Security benefits were not taxable at all. Initially, only 10% of recipients were subject to income taxes on their benefits, and the maximum percent that could be taxable was 50%. That was increased to 85% in 1993 when the Social Security Administration estimated that the total of worker payroll contributions, which had already been subject to income taxes, were about 15% of the total benefits received over their lifetimes. Currently about 60% of Social Security beneficiaries pay federal taxes on a portion of their benefits. Most states do not tax benefits.
Once you have reached the income level at which 85% of your benefits are taxable, any additional income will not raise your marginal rate any higher than your marginal tax bracket, all else being equal. But if you are below the 85% maximum, any additional income will be taxed at a rate higher than your marginal tax rate. This also means that if you can reduce your income in some way, such as by making an IRA contribution, realizing a tax loss, or taking less out of your retirement account in a particular year, the rate of tax savings will be greater than your marginal tax rate.
Social Security taxation should be taken into account in deciding when to start taking Social Security. It is tempting to start at full retirement age, even if still working, because you can earn as much as you want without having a portion of your benefits held back. But the combination of earnings from work and Social Security benefits could raise the portion of your benefits that will be taxed. Of course, if you have enough investment or other income so that 85% of your benefits will be taxed even without your working income, it may not matter from a tax standpoint, although waiting to begin benefits may be the optimal decision for you for other reasons.
Medicare Surcharge
Another tax trigger affects Medicare premiums. Sometimes a Medicare recipient is shocked to find that their monthly Part B and Part D premiums have increased substantially from one year to the next. It may just be temporary—for example, because of a large capital gain from a real estate sale, in which case the higher premiums will last just one year. Or if the recipient is still working and earning income, the premiums will fall after retirement. However, there is a lag, because Medicare premiums are generally based on modified adjusted gross income two years prior, which is what is available to the government when premiums are set for the year. For example, 2020 premiums are generally based on 2018 tax returns.
You have the right to appeal your higher premium if one of several qualifying reasons applies to you. The most common reason is that you’ve stopped working or are working fewer hours and your monthly income is much less. Other reasons for an appeal could be a change in marital status or a reduction or termination of a pension.
In 2020, the first income threshold is at $87,000 (single filers)/$174,000 (joint filers), at which Part B premiums rise from $144.60 per month to $202.41 per month and the amount added to Part D prescription premiums is $12.20 per month. The other income thresholds for single/joint filers are $109,00/$218,000, $136,000/$272,000, $163,000/$326,000, and $500,000/$750,000, at which Part B premiums rise to $289.20, $376.00, $462.70, and $491.60, and the Part D additional amounts are $31.50, $50.70, $70.00, and $76.40, respectively.
On the surface, the rationale for charging wealthier people more in premiums may seem to be related due to their greater ability to pay. However, a study from the National Bureau of Economic research found that while all Medicare enrollees receive more from Medicare in benefits than what they paid into the program in taxes, the windfall is greatest for the wealthy. Although wealthy enrollees pay more into Medicare than poorer people do in the form of general federal tax revenues and payroll taxes, they reap greater benefits over their lifetimes because on average they live longer and use more medical services.
Net Investment Income Tax
Another tax that affects higher-income taxpayers is the Net Investment Income Tax (NIIT), which was created by the Health Care and Education Reconciliation Act of 2010 and went into effect in 2013. A taxpayer is exposed to the tax only if modified adjusted gross income (MAGI) exceeds $200,000 for single filers or $250,000 for joint filers. (For most people, MAGI will be the same as adjusted gross income (AGI).) The tax of 3.8% is applied to the lesser of either (1) net investment income or (2) the amount by which MAGI exceeds those thresholds. Net investment income includes dividends, taxable interest, capital gains, taxable portion of annuity payments, rental income, passive business activities, and royalties, less investment expenses.
If you are subject to the tax because of the amount of your net investment income, taking capital losses or investing in tax-free rather than taxable bonds would be examples of how to lower the tax. If your MAGI is creating the exposure, making a retirement plan contribution would reduce your NIIT, as would taking a capital loss on an investment or investing in tax-free bonds.
Additional Medicare Tax
Also affecting higher-income taxpayers is the Additional Medicare Tax, created as part of the Patient Protection and Affordable Care Act (ACA). If your Medicare wages, on which you and your employer each pay 1.45% per year in payroll taxes, exceed $200,000 for a single filer or $250,000 for joint filers, you will pay an additional 0.9% on the amount your Medicare wages exceed those thresholds. (The employer does not also pay the additional tax.) This tax also applies if you are self-employed.
About The Author
Anne Christopulos
Anne is a Managing Director and Financial Planner with over twenty years of experience in the financial services industry. After holding corporate management positions in finance and strategic planning in New York City, she moved to Boston to become the Product Manager for the IRA business at Fidelity Investments. Following that, she was Vice President, Retirement Investments, at Fleet Financial Services. A native of Cape Cod, she returned to the Cape in 2001 and made the transition to personal financial planning with Secure Future Financial Services in Dennis and Davis Financial Services in Orleans before joining West Branch Capital. Anne holds a B.A. in music and economics from Wellesley College and an MBA from Harvard Business School.
Recent Articles
Categories
