When creating a long-term tax plan, the focus should not be on minimizing one year's tax liability, but rather on minimizing a family's lifetime liability.
This often takes the form of evaluating a person's current marginal tax rate and comparing it to their expected future marginal rate. If their current rate is lower, the conventional wisdom is to fill up the lower bracket(s).
But realizing income isn't always a simple arithmetic equation of adding just enough to stay in a lower tax bracket. Without careful thought, added income could end up being effectively taxed at a higher rate due to how the added income affects other aspects of one's taxes.
The following outlines several situations in which the tax impact of a change in income affects more than the marginal rate.
1. Social Security
Retirees who are collecting Social Security benefits often miss that the taxable portion of Social Security income depends on how much other income is claimed in a year. Adding a dollar of income could lead to increasing taxable income by up to $1.85 (as 85 cents of Social Security income is also added).
The Story: Nathaniel and Nadia are both 67 years old and started to receive a combined Social Security benefit of $40,000 in 2021.They also will receive $25,000 of taxable income from Nadia's pension. Their remaining cash flow needs are met through a cash reserve they have in a joint bank account.
Nathaniel has managed their tax plan and assumes the benefits are 100% taxable. Ultimately, he considers a Roth conversion to utilize as much of the 12% tax bracket as possible, bringing their taxable income (after the standard deduction is claimed) to a little under $80,000.
What Nathaniel does not realize is that before any Roth conversion, less than $7,000 of their benefits were taxable, resulting in a taxable income of less than $5,000 and federal income tax of about $500.
After a conversion of $40,000, $34,000 of their Social Security benefit is taxable, resulting in a taxable income of a little over $71,000, or approximately $8,000 of federal tax. In other words, the $40,000 Roth conversion increased their tax liability by $7,500 or an effective rate of nearly 19% — more than 1.5 times the intended 12% rate!
Medicare Premiums
The premium for the Medicare Part B program goes up at different income levels. Even adding $1 of income around these thresholds can move a person from one premium level to another. It is important to be aware of these thresholds when developing a tax plan.
Even realizing income that will be directly offset by a deduction can be expensive. The thresholds for Medicare premiums are impacted by adjusted gross income (AGI). Below-the-line deductions, such as charitable donations, will not help. For this reason, thoughtfully using qualified charitable distributions can produce significant premium savings.
The Story: Quincy, a 74-year-old bachelor, has a sizable IRA with a required minimum distribution in 2021 of $30,000. He also has portfolio income, a pension and Social Security benefits, which add up to $120,000 of income.
Quincy plans to give $30,000 to his favorite charity in 2021. Instead of completing his RMD, pushing his AGI to $150,000 and increasing his Part B premium from $297 a month to $386 a month (an increase of $1,069 for the year), he elects a QCD processed from his IRA.
