Written by: Tricia Rosen, CFP®, MBA, EA, Principal of Access Financial Planning, LLC

If you thought understanding your tax obligation while you were working was complex, just wait until you start retirement. There are 4 hidden taxes in retirement that make understanding and managing your tax obligations even more complex. AMT, IRMAA, NIIT, and the Social Security tax torpedo are taxes and surcharges you may never have heard of, but they can be significant additional expenses during retirement.

Many of these obligations were initially intended for higher earners, but they now impact people with more moderate income because they aren’t adjusted for inflation. For example, the net investment income tax (NIIT) affects people with modified adjusted gross income of $200,000 or $250,000 and above, depending on filing status. Increasing your awareness of the 4 hidden taxes in retirement helps you have a better understanding of how different sources of income in retirement can impact various taxes and surcharges.

Retirement Income is Different

In spite of the tax code being frustrating and full of jargon, most people close to retirement age have an idea of their approximate marginal tax bracket and are generally familiar with income tax principles since they have been filing returns for many years. In addition, since the passage of the Tax Cuts and Jobs Act in 2017, most people take the standard deduction and don’t itemize deductions, so there aren’t as many opportunities to manage their tax obligation.

However, the sources of income shift for many people as they transition away from a paycheck and into retirement or semi-retirement. The different sources of income in retirement can impact taxes and surcharges in unexpected ways. Since there is some flexibility with how to fund your retirement, understanding these taxes and surcharges is important to consider when you are choosing how to fund your retirement.

1. Alternative Minimum Tax or AMT

As it’s name suggests, the AMT is an alternative way of calculating the income tax a person owes. It is run in tandem with the standard federal tax system. The AMT calculation makes sure that higher earners pay at least a minimum amount of tax and can’t reduce their tax obligation too low by using various tax benefits. The AMT calculation has it’s own set of IRS forms, rules, rates, and tax brackets. There are also AMT exemptions which must be exceeded before the AMT is owed by the taxpayer.

Things that can trigger owing AMT are having a higher household income along with numerous itemized deductions, a large amount of realized capital gain, or exercising incentive stock options, which are typically offered at a discounted price. Even if you choose to not sell the exercised stock options right away, on paper there may be a profit which is taxable under the AMT calculation in spite of not receiving any actual cash for the stock yet.

AMT Impact in Retirement

Many retirees rely on their investment portfolios as a source of income. Selling assets which may have been held for a long time could incur a large capital gains tax obligation. While you are working you may choose to delay selling an asset with a large gain to delay the capital gains tax, but in retirement you may need or want to sell the asset to generate income. While capital gains generally qualify for the same lower rates under the AMT calculation as under the regular tax rules, a capital gain may cause you to lose part or all of your AMT exemption. Should you have to pay the AMT, you can take a credit against what you’ve paid in taxes in subsequent years when you don’t owe AMT. However, keeping track of the AMT credit can be cumbersome over time, especially if you change tax preparers, resulting in accidentally paying more tax than you owe in future years.

2. Net Investment Income Tax or NIIT

The second of the 4 hidden taxes in retirement that many people overlook is net investment income tax, or NIIT. NIIT applies to people with modified adjusted gross income (MAGI) above $200,000 for single filers and $250,000 for a couple filing jointly. NIIT is added to the capital gains tax owed when someone sells an asset. The NIIT amount is 3.8%, so the total tax someone may incur when selling an asset could be as high as 23.8%, not including state and local taxes if applicable.

NIIT is owed on net capital gain, dividends, and interest income. In addition to sales of securities from taxable accounts, it applies to interest on bank accounts and CD’s, dividends, rental income, and house sales for people who are selling their primary residence and their gain exceeds the exemption amount of either $250,000 for single filers or $500,000 for couples filing jointly who have lived in their house for at least 2 out of last 5 years. These are common sources of income for folks in retirement.

MAGI for NIIT Calculation

MAGI is not a standard term and is calculated differently depending on what it is being used for on a tax return. For the NIIT version of MAGI, Social Security benefits, tax-exempt interest from municipal bonds, and retirement account withdrawals are exempt. However, the income from all three can increase your modified adjusted gross income to a point where your total income exceeds the NIIT threshold and you may have to pay NIIT on other sources of income which you received and are not exempt from NIIT.

NIIT Impact in Retirement

While required minimum distributions (RMDs) from retirement accounts are not subject to NIIT, RMDs may push other investment income above the NIIT threshold. If a large portion of your retirement savings is subject to RMDs, it can become difficult to avoid NIIT on other income which is subject to NIIT. Most of the income sources which are subject to NIIT are common income sources for retirees, so it’s important to be aware of the total tax due when deciding how to create your income stream in retirement.

Roth Conversions

A way to reduce the size of your RMDs, and therefore your taxable income at the time of the RMD, is to consider Roth conversions. If you are in retirement and taking withdrawals from your retirement accounts, withdrawals from Roth accounts don’t count towards your gross income for NIIT. A Roth conversion, or a series of them over time to manage the income tax impact of the conversion, could reduce the future RMDs from traditional, pre-tax retirement accounts. Managing the timing and amount of your taxable income can result in lower overall taxes in retirement than if it wasn’t managed effectively.

With a Roth account, you pay the income tax at the time of the contribution, and when you take a distribution from the account both the principal you paid into the account as well as any growth on it can be withdrawn tax-free, with some exceptions. A traditional or pre-tax account is the opposite. You get a tax deduction at the time the contribution is made, and any withdrawals on the principal and growth later on in retirement are taxed as ordinary income. A Roth conversion means you transfer assets from your pre-tax, traditional IRA into your Roth IRA. The value of the assets transferred to the Roth account is considered taxable income at the time of the conversion. The additional tax incurred for a Roth conversion is balanced against future taxes and surcharges when deciding whether to do Roth conversions to reduce your overall tax obligation in retirement.

Tax Loss Harvesting

This tactic generally allows you to sell investments that are down in market value and replace them with reasonably similar investments, and then use the realized losses to offset realized investment gains, thereby reducing or eliminating the capital gain that is subject to NIIT. If the net result for the tax year is a capital loss, then up to $3,000 of the loss can be used to reduce ordinary taxable income for singles filers and marred couples filing jointly. Net capital losses that exceed $3,000 can be carried forward into future years to offset capital gains or reduce up to $3,000 in ordinary taxable income per year until the loss is used up.

Charitable Donations

Charitable donations for people who itemize deductions instead of taking the standard deduction can also reduce gross income and help to prevent you from crossing over the NIIT threshold. If you are of RMD age but you don’t need the income, you can consider making a qualified charitable distribution (QCD) from an IRA to a qualifying charity up to $100,000 per individual annually. A QCD won’t reduce gross income directly, but it can meet an RMD requirement and can help avoid withdrawals that would otherwise increase income. Anyone over 70 1/2 can make a QCD from an IRA and the amount of the QCD wouldn’t be subject to ordinary income tax.

3. The Income Related Monthly Adjustment Amount or IRMAA

The next of the 4 hidden taxes in retirement is affectionately referred to as “Aunt IRMAA”. IRMAA stands for income related monthly adjustment amount, and it is a Medicare related premium surcharge on Medicare Parts B and D, which are the medical services and prescription drug components of the federal health care plan. IRMAA is assessed on higher earning retirees based on a modified adjusted gross income (MAGI). The MAGI from the tax return filed two years prior to the current Medicare bill is used to calculate IRMAA.

Calculating IRMAA

The MAGI used for IRMAA is not the same MAGI that is used for NIIT. That would be too easy! The MAGI for IRMAA is the Medicare beneficiary’s adjusted gross income from their federal tax return plus any tax-exempt interest income. Generally speaking, the IRMAA is added to your monthly base premium for Medicare if your MAGI is above $103,000 for single filers and $206,000 for married couples filing jointly for 2024, based on tax return data from 2022. Additionally, IRMAA is a tax cliff, meaning you could owe an additional premium amount even if you earn just one extra dollar of income that bounces you into a higher marginal income tax bracket. It’s very easy to slip into a higher IRMAA bracket without realizing it and be stuck with the higher monthly Medicare premiums.

Managing IRMAA

Reduce Income

If you can, try to avoid large, income-generating financial transactions as you approach Medicare eligibility. Transactions such as real estate sales, distributions from retirement accounts, transactions with large capital gains such as stock or ETF sales, and Roth conversions can all increase your income and therefore your IRMAA surcharge. In addition, interest from federally tax-exempt municipal bonds contributes to your overall income when determining IRMAA, even though it isn’t considered taxable income. Similar to with NIIT, a QCD from a qualified retirement account to make a charitable donation does not count as income for IRMAA purposes.

You can request a reduction or elimination of the IRMAA if you’ve had a life changing event that may reduce your household income from what is stated on your tax return from 2 years ago. Examples of events which qualify are marriage, divorce, the death of a spouse, loss of work, or an employer settlement payment. You can request to use a more recent tax return that reflects the change in income which occurred due to the life changing event so that your IRMAA reflects your current financial situation more accurately.

Choose Withdrawal Strategy Thoughtfully

How and when you choose to withdraw from various accounts in retirement can have an impact on your income and the taxes you pay in different ways. The traditional approach is to withdraw money first from taxable accounts, then tax-deferred accounts such as traditional IRAs and 401(k)s, and then tax-free accounts such as a Roth account. However, it may be more advantageous to take withdrawals in a different order, or in some combination of taxable and non-taxable accounts in some years, which could result in a lower tax bill over time.

4. Social Security Torpedo

The last of the 4 hidden taxes in retirement is the Social Security torpedo. Social Security benefits are taxed according to your provisional income, which is essentially your modified adjusted gross income, plus nontaxable interest income, and one-half of your Social Security benefits for the year. And yet another variation of MAGI!

What is the Social Security Torpedo

Provisional income in excess of $34,000 for a single filer and $44,000 for a married couple filing jointly can result in up to 85% of your Social Security benefit being considered taxable income. Below these thresholds, a small percentage of your benefits are considered taxable income. The phenomenon called the “tax torpedo” occurs when your provisional income bumps you into a higher Social Security tax bracket.

This means that every additional dollar of income can have a double impact. The standard taxation of the additional dollar of income plus the taxation of another portion of your Social Security benefit. However, once you surpass the threshold where 85% of the Social Security benefit is taxed, then the double impact ends for any additional dollar of income.

How to Manage the Social Security Torpedo

To reduce the impact of the Social Security torpedo, it is often advisable to delay taking Social Security until age 70, if you can. In the meantime, you can draw down from pre-tax retirement accounts to pay for current expenses if needed. Drawing down from pre-tax retirement accounts will increase your taxable income now, but it will also reduce your adjusted gross income and your Social Security tax burden later on if your retirement accounts are smaller once RMDs begin. As with IRMAA above, being thoughtful and strategic about when and how you choose to withdraw from various accounts in retirement can have a significant impact your taxes over time, and it can help you manage your income to stay below higher Social Security provisional income thresholds that might result in paying more total taxes.

If you are retiring prior to age 70 and you aren’t starting your Social Security benefit yet, you can also consider a Roth conversion strategy that would reduce the amount of your future RMDs. Withdrawals from Roth accounts are not counted toward your provisional income. Similar to the strategy of drawing down from pre-tax retirement accounts now and delaying Social Security benefits, your current taxable income will increase now with a Roth conversion, but it will result in lower provisional income later on when you begin your Social Security benefit.

Strategies for Social Security Claiming

The additional benefit of waiting to claim your Social Security benefit is that you will receive a higher monthly benefit. For every year you delay past your full retirement age (FRA), you receive an 8% increase in your monthly benefit. That could be up to a 24% higher monthly benefit if you delay claiming until the maximum age, which is 70. Receiving a lifetime annuity with a cost of living increase built in that you have already paid for is a very valuable source of income for many retirees, and careful consideration should be taken when you are deciding when to begin receiving your benefit.

4 Hidden Taxes in Retirement Summary

Creating an income stream in retirement is more complicated than many people realize. One of the reasons it is more complicated is because of the impact the various decisions have on income taxes and surcharges. Most people aren’t aware of the taxes and surcharges which occur during retirement, or they don’t know enough about how they work to manage them effectively, which results in the 4 hidden taxes in retirement. The interrelationship between the sources of income and the various taxes and surcharges is not easy to decipher, but making the optimal decision can have a significant positive impact on your retirement funding. It’s worth the time and effort it takes to analyze the pieces of the puzzle and how they fit together.

Additional Information: 

As always, if you would like more information on how to create a tax-efficient income strategy in retirement, or any other financial planning topic, please contact me. Find out more about Access Financial Planning, LLC here

Disclaimer: This article is provided for general information and illustrations purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult with a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Tricia Rosen, and all rights are reserved. Read the full disclaimer.