LUTZ BUSINESS INSIGHTS

 

being mindful of the social security tax torpedo & medicare surcharges

nick hall, investment adviser

 

Social Security and Medicare are programs often at the forefront of retirees’ minds. The claiming strategies and rules can be very confusing for the average person. To complicate matters, timing decisions on claiming Social Security retirement benefits coupled with the withdrawal strategy decisions from an investment portfolio impact the amount of Social Security benefits that are taxed. In a related manner, higher income households need to be mindful of Medicare surcharges on Part B and Part D when going about determining withdrawal strategies in retirement.

Taxation of Social Security Benefits

The Social Security system is such a generous program that they tax people twice– pay/benefits are taxed on the way in (wages) and taxed upon receipt later in life. Jokes aside, under current law as little as 0% of retirees’ benefits are taxable but as much as 85% of retiree benefits are taxable for higher income households. However, a large portion of people fall somewhere in between in which some of their Social Security benefits are taxed but not the entire 85%. There is a calculation called provisional income which is used to calculate the amount or percentage of Social Security benefits that are taxable. Other income sources such as interest, dividends from investments, capital gains, rental income, pensions, IRA distributions, etc. affect this provisional income number.

It is in this range where William Reichenstein and William Meyer, head of research and CEO of Social Security Solutions, respectively, say people need to have an awareness of the self-coined phrase “tax torpedo”. The “tax torpedo” refers to the sharp rise and fall in marginal tax rates caused by taxation of Social Security benefits. I will highlight the “tax torpedo” in action in a hypothetical example below:

Sam and Sally Smith: Born in 1953 (Turn 66 this year), $50,000 of combined Social Security benefits, $15,000 of dividends from taxable investments, Sally $5,000 of pension income, and $30,000 of capital gains.

With the additional 50,000 of income and using the provisional income calculation, only $21,500 or 43% of Sam and Sally’s $50,000 annual Social Security retirement benefits are taxable. Assuming they filed the standard deduction, they would have an approximate taxable income of only $45,000 which places them in the middle of the 12% marginal Federal tax bracket. Even though they had $100,000 of income from Social Security and other sources, less than half of Social Security benefits would be subject to Uncle Sam. In fact, Sam and Sally could have up to $92,000 of other income (assuming the same $50,000 of annual Social Security) before the full 85% of Social Security benefits are taxable.

The Tax Torpedo in Action

People can get into trouble with respect to the “tax torpedo” when it comes to their withdrawal strategy from the investment portfolio during the distribution phase in retirement. In the above example, Sam and Sally might think it is a good idea to leak some money out of their traditional rollover IRA that came from an old employer’s 401(k) plan. On the surface, it appears they can take another $30,000+ out of the IRA each year and stay in the 12% Federal income tax bracket. However, what people fail to realize is that adding additional income from other sources inadvertently causes more of Social Security benefits to be taxable and increases the marginal tax rate of the transaction.

In Sam and Sally’s example, an extra $30,000 IRA distribution would cause $15,000 more of Social Security benefit taxation or a total of $36,500 to be taxable in that year. Sam and Sally’s new taxable income would be virtually doubled at approximately $90,000. More importantly, this creates about $12,500 in income that is now taxed at the 22% Federal bracket versus the much lower 12% Federal bracket. Assuming Sam and Sally are Nebraska residents and using a 6% Nebraska state tax, they added roughly $9,350 of additional income tax by innocently trying to leak out $30,000 from their pre-tax IRA while they were in a low tax bracket. Further, the tax torpedo doesn’t additionally adversely affect those whose high income already places them in a situation in which the maximum 85% of Social Security benefits are taxable.

Medicare Surcharges

For higher-income households in retirement, the acceptance of the full 85% of Social Security benefits being subject to tax is simply the reality. Another important concern begins to creep in for people who are over 65 and on Medicare. This concern relates to the income limits associated with Medicare Part B and Part D. A majority of the population will pay $135.50 per month for Medicare Part B premiums. However, high income households with modified adjusted gross income (MAGI) of over $170,000 for married filers ($85,000 for single filers) must begin paying an Income Related Monthly Adjustment Amount (IRMAA) or Medicare premium monthly surcharge. For Medicare purposes, income from two years prior affects the current years’ Medicare Part B premiums. The chart below details the Medicare Part B premiums based on income:

 

If your yearly income in 2017 (for what you pay in 2019) was You pay each month (in 2019)
File individual tax return File joint tax return File married & separate tax return
$85,000 or less $170,000 or less $85,000 or less $135.50
above $85,000 up to $107,000 above $170,000 up to $214,000 Not applicable $189.60
above $107,000 up to $133,500 above $214,000 up to $267,000 Not applicable $270.90
above $133,500 up to $160,000 above $267,000 up to $320,000 Not applicable $352.20
above $160,000 and less than $500,000 above $320,000 and less than $750,000 above $85,000 and less than $415,000 $433.40
$500,000 or above $750,000 and above $415,000 and above $460.50

Source: https://www.medicare.gov/your-medicare-costs/part-b-costs

 

As you can see, the highest income households end up paying $325/month more per individual for Medicare premiums. This equals $7,800 annually per married couple. Even the first jump represents a $1,296 increase in Medicare Part B premiums for a married couple. Unlike Social Security, Medicare surcharges are a cliff and the surcharges will be charged even if you exceed the MAGI threshold by $1. In addition to Medicare Part B, Medicare Part D (or Prescription Drug Coverage) includes a monthly surcharge as seen in the chart below:

 

If your filing status and yearly income in 2017 was
File individual tax return File joint tax return File married & separate tax return You pay each month (in 2019)
$85,000 or less $170,000 or less $85,000 or less your plan premium
above $85,000 up to $107,000 above $170,000 up to $214,000 not applicable $12.40 + your plan premium
above $107,000 up to $133,500 above $214,000 up to $267,000 not applicable $31.90 + your plan premium
above $133,500 up to $160,000 above $267,000 up to $320,000 not applicable $51.40 + your plan premium
above $160,000 and less than $500,000 above $320,000 and less than $750,000 above $85,000 and less than $415,000 $70.90 + your plan premium
$500,000 or above $750,000 and above $415,000 and above $77.40 + your plan premium

Source: https://www.medicare.gov/drug-coverage-part-d/costs-for-medicare-drug-coverage/monthly-premium-for-drug-plans

Two-Year Lookback and Request for Reconsideration of IRMAA Charges

The two-year lookback with respect to income can cause many people to pay high Medicare surcharges when initially going onto Medicare or certain times during retirement. However, the Social Security Administration is surprisingly forgiving when it comes to appealing these higher rates if there has been a significant life event that happened to give cause to an income spike or a reduction of income going forward like a sale of a business, inheritance, employer stock grants or deferred compensation, retirement, death of a spouse, etc. If you have had one of these major life events and now have a much lower income, it is most likely worth filing a request for reconsideration.

Planning for Tax Torpedo and Medicare Surcharges

An important tax planning strategy that we recommend to clients is Roth IRA conversions, the act of purposely moving money from Traditional IRAs to Roth IRAs. A great opportunity to do this is when people are in the first few years of retirement or what I call the “retirement income gap”, the time period before taking Social Security benefits or being required to take minimum distributions from pre-tax IRAs. The effectiveness of this strategy depends on delaying Social Security benefits and before RMDs happen at age 70 ½ to maximize lower tax brackets while not having to worry about the tax torpedo.

Because the Medicare surcharges are implemented on a cliff schedule, it becomes critically important to plan around this when possible during the distribution phase or determining a portfolio withdrawal strategy. Those with large pre-tax IRAs and big RMDs at age 70 ½, very large taxable accounts, pensions, rental income, or other higher ordinary income can be pushed into Medicare surcharge areas. Utilizing Roth IRA conversions and other tax strategies to accelerate income while people are in low tax brackets is a great solution to lower future income and manage Medicare surcharge cliffs. This can not only protect them against future tax rate increases but it can help minimize taxes at age 70 ½ and lower RMDs which kick off income that may adversely affect tax rates or Medicare premium surcharges.

The presence of the tax torpedo of Social Security benefits and Medicare premium surcharges add an extra layer of complexity for people in retirement. Developing a disciplined retirement withdrawal strategy and advanced planning can lower overall taxes during retirement by lessening the impact of the tax torpedo or helping avoid Medicare premium surcharges. As always, please consult with your CPA about any complex tax related question regarding these topics.

ABOUT THE AUTHOR

402.827.2300

nhall@lutz.us

LINKEDIN

NICK HALL, CFP® + INVESTMENT ADVISER

Nick Hall is an Investment Adviser at Lutz Financial with over eight years of industry experience. He specializes in comprehensive financial planning and investment advisory management services.

AREAS OF FOCUS
  • Financial Planning
  • Investment Advisory Services
  • Retirement Planning
  • Income Tax Planning
  • Social Security and Medicare Planning
  • Education Planning
  • Investment Product Research
  • Small Business Owners
  • High Net Worth Families in Transition
AFFILIATIONS AND CREDENTIALS
  • Financial Planning Association of Nebraska, Member
  • Certified Financial Planner
EDUCATIONAL BACKGROUND
  • BSBA in Finance and Business Management, Eller College of Management - University of Arizona, Tuscon, AZ
COMMUNITY SERVICE
  • Mount Michael Benedictine, Alumni Board President-Elect
  • Lutz Gives Back, Committee member
  • United Way, Volunteer
  • Salvation Army, Volunteer
  • Omaha Home For Boys, Volunteer
  • Susan G. Koman Race for the Cure, Volunteer

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