Don’t be Taken by Surprise in Retirement
Retirement Daily Guest Contributor
By Joseph Stenken, J.D.
Many people are aware that Social Security benefits may be taxable if the Social Security beneficiary has enough other income. Up to 85% of a person’s benefits might be subject to federal income tax. But what may be even more expensive, and unexpected, is the additional Medicare premiums that might be required for those in retirement with higher incomes. However, with proper planning, it is possible to avoid the taxation of Social Security benefits and also avoid higher Medicare premiums.
The rules and thresholds for the taxation of Social Security benefits have not changed since 1993. The threshold amount for including up to 50% of someone’s Social Security benefits in income is $25,000 for an individual, $32,000 for a married couple filing jointly, and $0 for a married person filing separately.
To determine whether someone exceeds the threshold amount, a person’s adjusted gross income is added to any tax-exempt interest and half of the Social Security benefits.
Up to 85% of Social Security benefits will be included in income if a person’s income exceeds $34,000 for an individual, $44,000 for a married couple filing jointly, and $0 for a married person filing separately. The 50% threshold amounts were put in place in 1983 and the 85% percent threshold amounts began in 1993 and have not been indexed for inflation, unlike many income tax numbers and thresholds. There are estimates that inflation from 1983 to 2020 has been nearly 160% and from 1993 to 2020 it has been about 80%.
Medicare Part B generally covers the services of doctors and other health care providers. Unlike Medicare Part A, which generally covers hospital stays, most people pay premiums to be covered by Medicare Part B. For 2020 the standard monthly premium for Medicare Part B is $144.60. This premium amount is higher for higher-income individuals. The income used to determine whether someone must pay higher premiums is adjusted gross income plus tax-exempt interest income. The following table shows the Part B premium amounts for 2020 based on income levels.
Up to $87,000
Up to $174,000
$87,000 - $109,000
$174,000 - $218,000
$109,000 - $136,000
$218,000 - $272,000
$136,000 - $163,000
$272,000 - $326,000
$163,000 - $500,000
$326,000 - $750,000
At least $500,000
At least $750,000
For married individuals filing separately, the following table shows the Part B premium amounts.
Married Filing Separately
Up to $87,000
$87,000 - $413,000
At least $413,000
While it is estimated that these income adjustments affect only 7% of those on Part B, the results for some can be dramatic. The maximum increase is $317 per month or over $3,800 per year per person on Part B.
Those Social Security beneficiaries who are taking required minimum distributions from qualified plans or individual retirement accounts (IRAs) may not be able to avoid the taxation of Social Security benefits or the higher Part B premiums. Other financial events could also cause a boost in income which could trigger taxation of Social Security benefits or increase Part B premiums. These events include the sale of a business or the sale of securities.
One strategy to try to avoid taxation of Social Security benefits and increased Part B premiums is to take taxable income, such as from qualified plans or traditional IRAs, before taking Social Security benefits or applying for Medicare Part B. This should be planned and coordinated with other income that might be received before and after starting to receive Social Security benefits. The idea is to minimize total taxation (and maximize after-tax income) over the time taxable distributions and Social Security benefits are received.
Distributions from Roth IRAs are not included in income and do not affect the taxation of Social Security benefits. These distributions also do not add to income to increase Medicare Part B premiums. So contributions to a Roth IRA as well as converting traditional IRA money to a Roth could assure income levels are low enough in retirement to not face the taxation of Social Security benefits or increased Part B premiums.
The use of permanent (cash value) life insurance, such as whole life insurance or universal life insurance, can also help lower the burden of taxation of Social Security benefits and additional Part B premiums. In general, when distributions are taken from a permanent life insurance policy there is an ordering rule that the money comes out as investment (premiums) first and then income next. And even then if money comes out of a permanent life insurance policy as a loan, that money will not be taxable. And if the policy is held long enough so that a death benefit is paid those loaned amounts will never be taxed.
Finally, deferred annuities can also be used to manage income in retirement. A person is not taxed on the income from a deferred annuity until there is a distribution. And deferred annuities are not subject to required minimum distributions while the annuity owner is alive. So a person holding a deferred annuity has the capability to manage distributions to therefore manage taxable income.
While the taxation of Social Security benefits and increased Medicare Part B premiums can be an unwelcome surprise in retirement, proper planning can avoid or mitigate these additional expenses. The best time to plan for these possibilities is long before retirement so investments are in their proper vehicles at retirement.
About the author: Joseph Stenken, J.D., CLU®, ChFC®
Joe Stenken is an Advanced Markets Product Consultant at Ameritas Life Insurance Corp. He is also a co-author of The National Underwriter Company’s The Tools and Techniques of Retirement Planning and Retirement Planning.