[Video] How Social Security & Medicare are Taxed: TIR 201 Part 2

Tim discusses the taxation of Social Security income in retirement and highlights the provisional income formula, which determines the taxable portion of Social Security. He also discusses how adjusted gross income can affect Medicare premiums, also known as Income Related Monthly Adjustment Amount or IRMAA.

Social Security Provisional Income Formula

Let's look at the provisional income formula and how Social Security is taxed. A lot of people don't realize that if all you have on your tax return in retirement is Social Security, then you're not going to pay any federal income tax at all. Also, you're always going to get about 15% tax free.

Then, based on your income or the thresholds that get applied to it, a lot of times you're going to end up paying a higher tax on your Social Security if you have other forms of income.

They use this thing called the provisional income formula. Basically it is half of your Social Security plus any other ordinary income that you have, and then they throw in non-taxable interest income too if you have any of that, or dividends or capital gains. Basically any other income you have plus half your Social Security.

Then they're going to lay some thresholds on top of that, and it's a little bit different for individuals as opposed to filing married. A lot of times advisors might say, you don't have to pay any tax or might say you have enough money coming out of your IRAs that you're always going to have to pay tax on 85% of your Social Security income.

But sometimes from middle class and upper middle class, there are some things that we can do to mitigate that and maybe make it so you don't have to pay as high as of a provisional income tax.

Scenario 1

The best way to show this is with a case study of something that actually happened. Let's say we have a couple and they have $20,000 coming in from Social Security. They've got $40,000 that they're taking out of their IRA because they're trying to get to $60,000 a year to live on.

To determine how the Social Security gets taxed, you take half of the $20,000, which is $10,000, and then they have $40,000 coming from IRAs, so they're going to have $50,000 of provisional income. Then they lay the thresholds on top of that, and that's going to say $11,100 or 55% of their Social Security is going to be taxable.

Scenario 2

Another scenario is that let's say you've got $40,000 coming from Social Security, and then you only need $20,000 coming from your IRA. That's going to cause $40,000 of your income to be part of the provisional income formula, because you've got half of the $40,000 in Social Security, which is $20,000, plus the $20,000 from your IRA.

So even though intuitively you think, Hey, I've got more coming from Social Security, so it's probably going to get taxed more, but that's not how it works. When you lay the thresholds on top of that, it's going to cause only $4,000 of your Social Security to be taxed, or about 10%, as opposed to the previous example that had a little over $11,000 of Social Security taxed.

So that's the kind of situation you have to look out for in retirement because all these different formulas and thresholds are going to cause you to pay a higher tax rate than is necessary without doing a little planning or laying the tax code on top of your retirement income situation. This is the kind of conversation about how or when to flip on your Social Security that you should be having with your advisor or you should be studying if you're doing this stuff on your own.

Medicare

On to Medicare excess premiums. A lot of people don't realize this either until you get close to retirement and close to turning 65 and starting to use your Medicare. Everybody knows you've been paying into Medicare your whole life, so once you turn 65, you get Part A for free, which is great.

But a lot of times people don't realize they have to start paying for parts B and D. And those amounts are going to be affected by your adjusted gross income. There's a table of the thresholds.

If you're sitting on a large pre-tax account, a lot of times what happens is retirees will realize they've just been paying the highest tax rate of their life and then hit 62 or 65 or whatever and they retire and they're like, Oh, perfect, I don't have a high tax rate at right now. I don't have any income coming in. We're just living off of our investments. We're going to flip on Social Security, so on and so forth.

But if you haven't done any planning, people are like, oh, right, this is great. Our tax rate is 10% or 12%. What you don't realize is that when you have a retirement nest egg and you get to RMD age, you have to start taking money out. And even if it's been pushed back to a later date, the amount that you're going to pay when it kicks on whether it's 73 or 75 is going to be higher because Uncle Sam still wants his share of the money.

Example

If you have not listened to anything so far today, listen to this story.

My cousin was talking to me about his in-laws. They've done great. Money is not the problem. They both have pensions. They retired from a great company. They've done well saving. They've done what they want, but they're savers. They've been very prudent, investmentwise, and they have a good pre-tax account, but they've never laid the tax code on top of their income.

My cousin's father-in-law was telling him they have to start taking RMDs next year. They are going to be 73. They have been happy with how low their tax rates been since they retired. But now they're going to start taking required minimum distributions next year and that's going to kick them up into 32% tax bracket.

They've been retired about 8 or 10 years,. Clearly they're not clients of our firm. What has happened is they retired, and they tried to pay a super low tax rate. Now RMDs are going to kick in next year and not only are they going to be in a 32% tax bracket, but this is going to kick them up about four or five brackets on income related monthly adjustment amount that they'd have to pay in Medicare.

So not only are they going to pay a 32% tax rate, which is higher than they needed to pay if they had done some proper tax planning, but they're also going to have to pay almost $12,000 a year extra for Parts B and D premiums on their Medicare.

Even though your tax rate is higher than it needs to be, when people find out that they're going to have to pay that premium that usually can be that much higher every single year on their Medicare, that really irritates people.

They say Why didn't my advisor tell me this or I wish I had done more research or whatever it might be. Yeah, that's a lot of money just going to Uncle Sam because, unfortunately, there wasn't some proper tax planning done.

So, remember that story because if you're sitting on a big pre-tax account and you're not doing anything tax-wise in your gap years, whenever you have to start taking money out for your RMDs, it's going to cause your adjusted gross income to go higher, and you're not only going to have to pay a higher tax rate than you probably needed to, but you're also going to have to pay an excess premium that could be you know, another $5- $6-, $10-, $12,000 or even a higher amount per year in Medicare surcharges, so definitely keep that in mind.

That one really bothers people, for other obvious reasons. Why do you want to pay $12,000 more a year in Medicare than you needed to. What you need to do is some proper tax planning, laying out a tax map, and having an idea what you're going to do and do some proper tax planning with a tax advising professional to be sure that you lay the tax code on top of your retirement income situation.

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