Why your clients might face higher taxes in retirement

We must stay ahead of the curve if we want to best serve our clients. One critical issue that demands our attention is the likelihood that our clients might face higher taxes in retirement.

For decades, conventional wisdom has suggested that retirees fall into lower tax brackets. Today, shifting financial landscapes and policy changes indicate that this is no longer a fact we can count on.

Changes to Social Security taxes

Do you remember when Social Security benefits were not taxable? Before the 1980s, retirees enjoyed their Social Security benefits tax-free.

As you know, tax laws are different today, and Social Security is taxable for most beneficiaries. To determine how much a client’s Social Security is taxed, we look at their provisional income. We calculate this by adding half of their Social Security benefits plus all their other taxable income, including dividends, interest, capital gains and withdrawals from tax-deferred accounts.

Depending on your client’s provisional income, up to 85% of their Social Security benefits may be subject to taxes. We know that currently, a base income of $32,000 or less for married couples filing jointly results in no taxation. However, $32,000 to $44,000 means 50% of the benefits may incur taxes. More than $44,000 pushes up to 85% of your clients’ benefits into the taxable column.

Given that these thresholds have not been indexed for inflation, an increasing number of retirees are finding themselves liable for Social Security taxes. This especially applies to those among your clients who have been diligent savers.

This system has effectively created a “tax torpedo,” where additional income, such as required minimum distributions, significantly increases the tax burden on Social Security benefits, leading to tax rates that exceed 40%.

Medicare and its impact on retirement planning

Medicare Part B and Part D premiums are also influenced by your clients’ income levels. Your higher-income retirees are subject to the income-related monthly adjustment amount, meaning they’ll face increased premiums based on their modified adjusted gross income.

A higher MAGI often pushes retirees into higher IRMAA brackets, drastically increasing health care costs. This is typically worse for clients with substantial tax-deferred saving, as these withdrawals count toward their MAGI. It seems particularly unfair, but your clients who have been diligent savers will face higher Medicare costs even though they receive the same benefits as people who saved less.

The risk here is twofold. First, elevated income increases Medicare premiums, and second, it reduces your clients’ net Social Security benefits. This is because these premiums are often deducted directly from Social Security checks.

Tax-deferred investments and required minimum distributions

Tax-deferred investments such as individual retirement accounts and 401(k)s are popular retirement savings vehicles due to their tax advantages during your client’s accumulation phase. However, these benefits come with a deferred tax liability. Once retirees reach age 73 (if born before 1960, 75 if born in 1960 or after), they must start taking the required minimum distributions. This can push them into higher tax brackets and expose more of their Social Security benefits to taxation.

RMDs represent a significant source of taxable income in retirement. The mandatory nature of these distributions can lead to substantial, often unexpected, tax bills. For example, large distributions may push retirees into higher tax brackets, triggering increased tax rates on ordinary income and Social Security benefits.

Your clients who fail to take their RMDs will face substantial penalties. Therefore, it is vital to have a thorough understanding of how these withdrawals fit into the broader tax picture.

Strategies to help avoid the tax torpedo

The tax torpedo effect occurs when RMDs and other income significantly increase provisional income, resulting in higher overall tax rates. Careful planning around provisional income is essential to mitigate this effect.

One effective strategy is to convert tax-deferred accounts to Roth IRAs. This can be particularly beneficial when your clients are in lower tax brackets, such as the period before they begin claiming Social Security benefits or are forced to take RMDs. A strategic Roth IRA conversion can help distribute the tax hit over several years.

Unlike traditional IRAs, Roth IRAs do not require RMDs during the account holder’s lifetime. This can be a powerful tool for long-term tax planning, reducing taxable income in retirement and preserving wealth for future generations.

Encourage your clients to diversify their investments across different types of accounts — taxable, tax-deferred and tax-exempt. This diversification offers flexibility in managing tax liability throughout retirement. For example, your clients can implement a tax-efficient withdrawal strategy that significantly impacts the tax efficiency of their retirement portfolios. With a thoughtful sequence of withdrawals — initially tapping taxable accounts, followed by tax-deferred accounts and finally, tax-exempt accounts, you can enable them to manage taxable income levels effectively.

If your clients are charitably inclined, qualified charitable distributions allow them to donate up to $105,000 directly from their IRAs to qualifying charities when they reach age 70½. These distributions are excluded from taxable income. This effectively reduces the amount subject to RMDs and diminishes a client’s overall tax burden.

Cash-value life insurance policies can serve as another instrument to reduce taxable income. Because withdrawals and policy loans from these accounts are generally tax-free, they offer your clients another stream of income that won’t add to their provisional income.

Another strategy involves using health savings accounts. HSAs offer triple tax advantages: Contributions are tax-deductible, growth is tax-free and withdrawals for qualified medical expenses are also tax-free. Encouraging clients to use HSAs can provide another source of tax-free income in retirement.

Finally, encouraging clients to delay claiming Social Security benefits until age 70 can increase their monthly benefit amounts and potentially reduce taxable income during the early years. This can provide a higher guaranteed income later in life, potentially with a lower tax impact.

Advanced modeling tools and software can help you demonstrate all this data and project future RMDs, tax liabilities and the overall financial landscape of retirement. These projections can help you guide your clients through the complex decisions on when and how to convert traditional IRAs to Roth IRAs, the timing of Social Security benefits, and other tax-efficient strategies.

The idea that retirees will automatically fall into lower tax brackets is increasingly becoming a myth. As lifelong savers approach retirement, the interplay of tax-deferred investments, Social Security taxes, and Medicare premiums can result in an unexpectedly high tax burden. 

As financial advisors, you are responsible for guiding clients toward proactive planning and effective strategies to mitigate these tax risks. By understanding the nuances of provisional income, leveraging Roth conversions, adopting charitable distributions, and implementing tax-efficient withdrawal strategies, you can help your clients achieve a financially secure and tax-efficient retirement.