Income tax tips every retiree should know
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While the tax code remains a constant, different rules are relevant during your working years and retirement. The rules and strategies centered on saving for retirement in a tax-efficient manner fade to a distant memory, and a new set of rules around spending and withdrawing sink in.
Social Security Tax Torpedo
Many people are surprised that Social Security benefits are subject to Federal income tax. Yes, you paid into the Social Security system through FICA taxes during your working years, and when it’s your turn to collect benefits, the government wants its portion, too. The amount of Social Security benefits subject to taxes is calculated on a sliding scale based on your income. Low-income Americans don’t pay any tax on their Social Security benefits, while most people pay tax on 50-85% of their benefits.
Individuals with income between $25,000 and $34,000 and married couples with income between $32,000 and $44,000 will pay income tax on up to 50% of their Social Security benefits. For every dollar of income above the upper threshold, an extra $0.85 of Social Security benefits become taxable until 85% are taxable. In the worst-case scenario, this can push taxpayers out of the 0% long-term capital gains bracket and increase their effective tax rate by double-digit percentage points. This is known as the Social Security tax torpedo.
State Rules
Not all state income tax codes are created equal. Eight states don’t charge any income tax at all. One state, New Hampshire, only taxes interest and dividend income. Eleven states tax Social Security benefits, while 41 states do not. In Indiana, retirees don’t have to pay state income tax on Social Security benefits. Illinois, along with three others, doesn’t charge income tax on any retirement income, including IRA withdrawals and pension benefits.
State tax calculations differ significantly from federal tax calculations, which is important if you plan to make estimated tax payments during retirement.
It’s also important when taking advantage of certain state tax credits. Some tax credits are nonrefundable. You may have qualified for the full credit during your working years, but that doesn’t necessarily mean you can take full advantage in retirement.
A nonrefundable tax credit reduces your tax liability dollar for dollar but cannot provide a refund. Indiana’s favorite tax credit, the 529 credit of 20% on up to $7,500 of Indiana 529 contributions, is nonrefundable. So, if your Indiana tax liability is $1,000 and you contribute $7,500 to your grandchild’s Indiana 529 plan, you would only get to use $1,000 of the $1,500 tax credit.
Medicare Premiums are Income-Based
One of the biggest surprises to retirees is the fact that Medicare Part B and Part D premiums are based on income. Specifically, premiums are determined by your Modified Adjusted Gross Income (MAGI) from two years prior. In 2025, the Social Security Administration will charge increased premiums on individuals who reported 2023 MAGI above $106,000 and married couples with 2023 MAGI above $212,000.
The additional premium is called Medicare Income-Related Monthly Adjustment Amount, or IRMAA for short. Premiums increase across five tiers, with the highest premiums applying to individuals with MAGI above $500,000 and $750,000 for married couples filing jointly. The Social Security Administration allows Medicare participants to appeal if their income is expected to be lower based on a life-changing event, such as retirement, marriage, divorce, or the death of a spouse.
It’s crucial to remember the IRMAA thresholds when planning for retirement. Whether converting pre-tax assets into Roth accounts or starting to draw Required Minimum Distributions from IRAs, even one dollar over the threshold could cost you a year of increased premiums.
Summary
In retirement, the focus shifts from deciding whether to make traditional or Roth 401k contributions to which income sources to tap, how much to withdraw, and when. Making the wrong decision can have significant tax consequences, so working with a financial advisor is essential to help you navigate these complexities.
Kate Sullivan, CFP, is a Wealth Advisor with Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website at www.bedelfinancial.com or email Kate at ksullivan@bedelfinancial.com.