Are You at Risk of Getting Hit With Stealth Taxes?

This post may contain affiliate links which may compensate us based on your interaction. Please read the disclosures for more information.

Don’t take withdrawals from your retirement accounts without understanding this first. 

When it comes to funding retirement, most Americans turn to their pre-tax accounts. 401(k)s, 403(b)s, and IRAs are popular savings vehicles and account for the bulk of pre-tax retirement savings among Americans. However, withdrawing from these accounts could spring a series of traps, commonly referred to as stealth taxes. What are common stealth taxes and how do they work? Read on to learn more.

Read more: The Ascent’s complete guide to taxes

Higher marginal tax rates

The basis of stealth taxes is this: withdrawals from pre-tax savings accounts count as taxable income. This nuance can send unexpected shock waves through your retirement plan. The most obvious of these is in the form of income tax brackets.

Pre-retirement savings are very common among Americans — and for good reason. Deferring your income on a pre-tax basis into an employer retirement plan, such as a 401(k) or 403(b), or into an individual retirement account, yields two major benefits. First, savers build an asset base which can be drawn from in retirement. Second, a saver’s income is reduced by the amount of their contribution in the year in which they contributed. The complications come into play when you draw down these assets in retirement.

The government, at the state and federal level, wants to encourage Americans to save for retirement, so do not tax money contributed to qualified retirement accounts. However, the government is not willing to forfeit their tax revenue entirely. While contributions to pre-tax retirement plans are not taxed, all withdrawals from these accounts, including both contributions and earnings, are fully taxable. So those in retirement should anticipate paying taxes, even though they may not have traditional earnings in retirement.

Social Security tax

Many retirees view Social Security as an integral piece of their retirement plan. However, not every Social Security recipient recognizes that their benefits may incur a tax liability. And if you aren’t careful, your retirement account withdrawals could lead to more of your Social Security benefits being taxable.

Part of your Social Security income may be taxable depending on your combined income. Your combined income is a metric used by the Social Security Administration, and factors in your adjusted gross income. If your combined income is below $25,000 for individual taxpayers or $32,000 for joint filers, none of your Social Security benefits are taxable. Should your combined income exceed that, up to 85% of your benefits may be taxable, subject to certain thresholds.

Recognizing a larger portion of your Social Security benefits as taxable income is a common stealth tax. When you withdraw assets from your pre-tax retirement accounts, you must count those assets as taxable income. And if that additional income puts you over the threshold to be taxed on your Social Security benefits, the difference could potentially be thousands of dollars in tax liability.

Medicare premiums

Medicare is another government program commonly used by retirees. While Medicare Part A, commonly referred to as hospital insurance, is free of cost for most people, certain Medicare benefits come at the price of a monthly premium. This premium is not the same for everyone — those recognizing higher income may have to pay more every month for the same coverage.

Both Medicare Part B (medical insurance) and Part D (drug coverage) charge retirees monthly premiums. While many retirees pay a standard premium for these coverages, those with higher income may be subject to a surcharge. Income Related Monthly Adjustment Amount, or IRMAA, may increase your monthly premium based on your modified adjusted gross income and how you file taxes.

As stated above, withdrawing from a pre-tax retirement account raises your taxable income. This higher reported income could lead to paying higher premiums for Medicare Part B and D coverage. While the vast majority of people will not be subject to IRMAA, the highest IRMAA surcharge could see you paying a premium of nearly 3.5 times the base premium.

By understanding the implications of stealth taxes, you can optimize your retirement income plan. Recognizing that pre-tax savings are taxable income is a good first step, but you should also recognize that this income may have ripple effects when it comes to how your Social Security benefits are taxed and how much you’ll pay for Medicare coverage. Stealth taxes in retirement may be costly, but they are far from inevitable for the knowledgeable retiree.

Our picks for best tax software

Our independent analysts pored over the perks and user reviews for the most popular tax provider services to land on the best-in-class picks to file your taxes. Get started by reviewing our list of the best tax software.

We’re firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers.
The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.The Motley Fool has a disclosure policy.

 Read More