The Four Horsemen of Retirement Tax Planning

These four points may come to haunt you in retirement, but making a plan in the present can help address these known risks. Each one is capable of sapping away spending power in retirement by increasing your tax liabilities. Instead of copying and pasting paragraphs of legislative law, I want to share with you the real life impact on a hypothetical retired couple.

Consider Bobby and Sue, a married, retired couple in their early 70s who are collecting Social Security and starting the required minimum distributions (RMDs) that the IRS requires once you turn 72. While working, Bobby and Sue did everything they were told to maximize tax-deferred savings, accumulating a $1,000,000 pre-tax 403(b) from Bobby’s time as a nurse and a $1,000,000 IRA from Sue’s work as an executive. They also invested outside of their work accounts, accumulating an additional $1,000,000 in a brokerage account invested in dividend-paying stocks.

We can call this the Penalty Case, and it is one of the four horsemen of retirement tax planning. There is no telling when or if your spouse might predecease you, but without planning the likely outcome for retirees with higher income and net worth is more taxes.

If you are keeping close watch you might point out that I did not include any capital gains in the Base Case or Penalty Case – in any year that the survivor Sue has a meaningful amount of capital gains there are even more taxes to pay. These taxes could also apply in the Base Case with Bobby and Sue, but this next horseman kicks in at a lower income level for a single filer compared to a couple.

Capital gains, interest, dividends, rental & royalty income, non-qualified annuity income, and income from businesses involved in trading are all potentially subject to net investment income tax (NIIT). This tax is triggered when single tax filers have adjusted gross incomes of at least $200,000 (married couples $250,000). The NIIT tax of 3.8% applies to the amount in excess of the trigger.

If we model capital gains of $100,000 in a year after Bobby’s death (we will call this the NIIT Case), Sue will pay $1,277 in NIIT taxes because Sue will have $33,600 of investment income in excess of the $200,000 ceiling for single filers. Sue’s total tax liability is expected to be $36,248; a married couple in the same situation would have only paid $34,945 (none of which is NIIT).

There are close to 64 million individuals insured by Medicare. Using 2022 figures, on average, an individual will pay $170.10 per month for Part B and about $33.77 for a Part D prescription drug plan. What most people do not realize is that the $170.10 is only 25% of the actual cost of Medicare Part B premiums – the other 75% is subsidized and paid by the government (Parts C and D are also subsidized but under a different formula). This next horseman, IRMAA, is a reduction of that subsidy. It can appear in the Base Case and the Penalty Case, but how hard the IRMAA hits depends on the modified adjusted gross income (MAGI) for the taxpayer(s). In Bobby and Sue’s Base Case, they are able to avoid IRMAAs because their MAGI is under the cutoff of $182,000. However, if they have a large sale or an unexpected windfall, the subsidy provided by the government starts to wane, and Bobby and Sue will begin to pay 35% to 85% of the premium for Medicare Part B, depending on the amount of the new income.