In 1983, the United States changed the rules of engagement when it unveiled the first Stealth Aircraft—the F-117 Nighthawk. The goal was to make a plane that was undetectable to the enemy. The new design didn’t make it completely invisible to radar, but it made detection much more difficult.
It’s possible you may have to deal with some stealth attacks against your income. Like the Nighthawk, Stealth Taxes are not completely invisible, but detection is difficult if you’re not looking for them and they can sneak up on you during your working career or in retirement. Without an advance battle plan, these Stealth Taxes can increase your income tax liability and reduce after-tax retirement income.
10-Year Payout Rule
This is the newest of the Stealth Taxes. It’s a result of the SECURE Act that took effect in 2020 when changes were made to the way distributions are handled from inherited IRAs.
Under the old rules, if you inherited an IRA, you were required to take a distribution every year based on your age and you could stretch those required distributions across your lifetime, thus the name “Stretch IRA.”
But now, beneficiaries of inherited IRAs have to take all the money out by the end of the tenth year after the death of the person who gave them the IRA. The money can be taken out in installments or as a lump sum.
Watch closely–there are a couple of Stealth Taxes on the radar here. First, the 10-year payout rule forces beneficiaries to pay taxes on the entire IRA sooner than under the old rules. Shortening the time to liquidate the IRA eliminates years that the money could have been growing which means less money for you in the long run.
The other Stealth Tax from the 10-year rule swoops in if there is any money left in the inherited IRA at the end of the ten years. The IRS will assess an “additional tax on excess accumulations” of 50% of what’s left in the IRA plus interest.
People exempt from the 10-year payout rule are surviving spouses, children of the deceased who have not reached the age of majority, beneficiaries who are disabled, chronically ill beneficiaries, and a beneficiary not more than 10 years younger than the deceased. All these beneficiaries can still stretch the required distributions across their lifetimes.
Widow(er)’s Income Tax Penalty
This is one of the most obscure taxes in the IRS code. It has the potential to significantly increase the amount of taxes a surviving spouse pays. A widow or widower who has the same or less income than before the death of their spouse is often pushed into a higher federal and state income tax bracket because they transition from married filing jointly to single tax rates. The standard deduction is also cut in half moving from married rates to single.
Tax on Social Security
Whether you pay taxes on your Social Security and how much you pay is based on your combined income, which is the total of your adjusted gross income plus nontaxable interest plus half of your Social Security benefit. The reason this tax sneaks up on you is because the income threshold is so low.
Single individuals with a combined income of $25,000-$34,000 and joint filers with combined income between $32,000-$44,000 pay tax on up to 50% of their Social Security. Single filers with income above $34,000 and couples filing jointly with income above $44,000 have to pay taxes on 85% of their Social Security. The problem here is that combined income amounts have never been adjusted for inflation since taxing Social Security began in 1984.
Medicare Part B Premiums
Every year Medicare sets the amount charged for Part B. In 2021 the amount is $148.50. But if your income is higher than Medicare thinks it should be, then you get charged more. Officially it’s called an Income Related Monthly Adjustment Amount (IRMAA). If you’re a single taxpayer with income above $88,000 or joint filers with income above $176,000, your monthly premium may be as high as $504.90. Part D prescription drug coverage premiums can go up, too.
You may think you won’t have substantial income that would drive up your premiums, but it may happen if you sell a rental property, any kind of property with a taxable gain, large IRA distributions, or a sizable Roth IRA conversion.
Net Investment Income Tax
This is really a surtax paid by high-income taxpayers who have substantial investment income. Single taxpayers with Modified Adjust Gross Income (MAGI) above $200,000 and married filing jointly taxpayers with MAGI above $250,000 pay 3.8% of their net investment income which includes capital gains, interest, dividends, rental income, royalties, and nonqualified annuity income. The Net Investment Income Tax is on top of the 15% long-term capital gains rate and the 20% short-term capital gains rate you pay.
Limitation on Personal Income Tax Deductions
All the stealth taxes we’ve talked about so far directly increase taxes and premiums. The $10,000 limitation on income tax deductions eliminates a chunk of deductions that used to be available, reducing itemized deductions that were helpful to many taxpayers.
Part of the change included a doubling of the standard deduction. There were also changes that reduced mortgage interest deductions. The result—the number of taxpayers itemizing their deduction went from 31% in 2017 to 14% in 2019.
As you plan for retirement, make sure you take these stealth taxes into account. The chance of them going away is slim, since they raise billions of dollars in tax revenue every year. In addition, stay informed. Don’t let your retirement plan be derailed if new stealth taxes are instituted under the radar.
This article is presented as information only and should not be considered tax or legal advice.