The Top 5 Retirement Tax Surprises - and How to Plan Ahead
Most of us see retirement as the end goal. You work hard all your life, paying taxes every year and investing for the future. Now it’s your time to kick back and relax.
But guess what. Just because you’re taking an extended break, doesn’t mean the government or the IRS are. Many retirees find themselves blindsided by these extra taxes or penalties. The good news is, with some proper planning, you can avoid most of these extra expenses.
1. IRMAA – Medicare Surcharge
Although this isn’t a tax, it’s still a surprise cost in retirement that should be on your radar. There’s a cost for Medicare, especially Part B (medical insurance) and Part D (prescription drug coverage), and those costs are based on your income. If your modified adjusted gross income (MAGI) is above certain limits, you may be subject to Income-Related Monthly Adjustment Amounts (IRMAA).
These thresholds are based on your MAGI from 2 years ago, and once you cross the next threshold (even by a dollar), you’re stuck paying the higher price all year. These price increases aren’t small either, they can add up to thousands of extra dollars per year.
To help minimize these costs, it’s essential to plan ahead, years ahead. Early Roth conversions can help reduce taxable income in retirement, if it makes sense for your situation. Selling your business before age 63 or using an installment sale can help reduce IRMAA considerations. Stock piling harvested tax losses to offset capital gains can also be a useful strategy.
Remember, the IRMAA charge is based on your MAGI from 2 years ago. Since Medicare generally starts when you reach age 65, you’ll want to plan your income from the tax year you turn 63.
2. Required Minimum Distributions (RMDs)
RMDs are designed for the government to finally be able to collect taxes on all your tax-deferred retirement savings. Once you hit age 73 (formerly 71 ½ and changing to 75 in 2035), you’ll be required to make annual withdrawals from traditional retirement plans (IRAs, 401(k)s, etc.).
The amount is based on your cumulative tax-deferred account balance at the end of the previous year, divided by your life expectancy (based on IRS tables). This generally must be taken by the end of the current year and is fully taxable as ordinary income. Failure to withdraw the entire RMD amount will result in a penalty of 25% of the difference between the full RMD amount and the amount actually withdrawn.
To avoid a massive tax burden caused by RMDs, there are a few strategies. You can do Roth conversions – Roth accounts aren’t subject to RMDs, you can steadily reduce the balance of your pre-tax accounts by withdrawing from them earlier, and/or you can make qualified charitable distributions (QCDs). The first two strategies will reduce the size of your RMDs, thus reducing your tax liability. The QCDs will directly reduce the taxability of your RMD.
QCDs can be made if you are over 70 ½ years old, but the money must go directly from your pre-tax account directly to a qualified charity. You can’t take possession of the funds at all. You can donate up to $108,000 (indexed for inflation) through QCDs in 2025.
Remember, RMDs are fully taxable as ordinary income. Having large RMDs will not only increase your tax liability, but it may also increase your IRMAA charges.
3. Net Investment Income Tax (NIIT)
There’s a good chance that you’re already aware of this tax, but for those who are not, it’s an additional 3.8% tax on investment income. This only applies if your MAGI is above $200,000 (single) or $250,000 (MFJ), and it applies to the lesser of your net investment income, or your income over the threshold.
Many people think this tax goes away once you retire, but they are wrong. Since this is only a tax on investment income, it doesn’t impact distributions from traditional or Roth retirement accounts, but distributions from traditional accounts will still count toward your MAGI threshold.
Some common strategies to help reduce or avoid this tax include Roth conversions (since Roth distributions aren’t included in MAGI), tax-loss harvesting to offset gains, and investing in tax-free securities (like municipal bonds).
4. Social Security – Taxable Benefits
Depending on your income, your Social Security benefits may be partially taxable. If your combined income – calculated as one half of your Social Security benefits plus other taxable income sources – is over a certain limit, part of your Social Security income will likely be taxed.
The current income limits are tiered and are relatively low, with the highest limit being $44,000 for married filing jointly taxpayers. These limits aren’t adjusted for inflation, and being over the threshold can cause up to 85% of your Social Security benefits to be taxable.
With such low limits, this one is hard to avoid, but it can be done. Income from Roth accounts isn’t included in the calculation, and tax-loss harvesting can be used to offset capital gains.
5. Estimated Taxes
You’re retired now, so gone are the days of mandatory tax withholdings from your paychecks. You may think it’s fine to put off paying taxes until you file, but you would be wrong.
The IRS requires taxes to be paid as the income is received. If you only receive income once per year (highly unlikely, but possible), then you might get away with only paying when you file. However, since this isn’t generally the case, it’s prudent to have a system in place to pay taxes throughout the year.
Failure to pay taxes in a timely manner can result in underpayment penalties. You’ll likely owe interest on the amount of underpayment too!
These penalties can be avoided by having taxes withheld from pre-tax account distributions, and/or making quarterly estimated payments. You don’t necessarily need to have your entire tax liability withheld (or paid through estimated payments), but you do want to make sure you at least hit the safe harbor amount.
Final Thoughts
Retirement should be about enjoying life, not worrying about tax bills or other surprise fees. By understanding IRMAA, RMDs, NIIT, and Social Security taxation, you can be better situated to conquer retirement.
Proactive financial planning can really help you get ahead of these costs, giving you more control over your retirement. Strategies like Roth conversions and tax-loss harvesting can help reduce future RMDs, IRMAA charges, and potential NIIT, which helps lessen your overall tax liability. Using a combination of account types (Roth, pre-tax, and taxable) can give you the flexibility to manage and control your income and taxes.
What you do now can have a substantial impact on your future, especially where taxes are concerned. If you’re worried your financial plan isn’t optimized to reduce your lifetime taxes, or you just want a second opinion, scroll down to get your free, no-obligation Introductory Conversation scheduled. We’ll be happy to help.
