The whole purpose of retirement income planning is to optimize your retirement funds as much as possible. However, besides owning an adequate amount of retirement assets, there are two other ways in which you can achieve this goal: you can either maximize your income or minimize your income tax liability.

In fact, there are around six stealth taxes that might increase your income tax liability but also reduce your lifetime after-tax retirement income. Except for only one, all of them have been in use for several years now. Even if some of them are a bit hard to avoid because of their low-income threshold, you should still plan ahead and continue throughout your retirement. Here are the 7 ground rules you need to know about the stealth tax:

The 10-year payout rule

Let’s discuss the latest news: the 10-year payout rule. The rule was made by the SECURE Act and is usually effective for deaths that occurred after December 31, 2019. It also applies to beneficiaries of retirement plans and IRA accounts.

It seems that surviving spouses, children who are still under 18 years old but aren’t grandchildren, and other “eligible designated beneficiaries” won’t be affected by the 10-year payout rule. They might continue to take different distributions from retirement plans and IRA accounts over their lifetime by deciding to use the minimum distribution or RMD.

However, after reaching a certain age, children and grandchildren will be classified as non-eligible. They will no longer be able to take RMDs from their retirement and IRA accounts. Instead, they might be subject to the new 10-year payout rule, where they have to empty the given accounts by the end of the tenth year after their death.

Distributions could be taken evenly over the course of ten years, or even in random years, as long as there’s no balance left in your retirement or IRA accounts. Two potential examples of stealth taxes were specifically designed for the 10-year payout rule.

The first one takes the form of accelerated and increased income tax liability compared to the RMD rules. However, the second one is a potential penalty that’s been assessed by the IRS as an “additional tax on excess accumulations” of no less than 50% plus interest on the balance of funds that remains in retirement plans or IRA accounts at the end of the tenth year.

Social Security

Taxation of the Social Security benefits started in 1984, and it is by far one of the most difficult to avoid stealth taxes, and it’s all due to the low-income threshold. This threshold makes reference to “combined income”, which is the total amount of adjusted gross income, nontaxable interest, and half of your Social Security benefits.

Single individuals who have a combined income of $25,000 to $34,000 are bound to be taxed up to 50% of their benefits and up to 85% on amounts above $34,000. Also, joint return filers who own a combined income of $32,000 to $44,000 are taxed on up to 50% of benefits and as much as 85% on amounts above $44,000.

However, Social Security is different than other income-sensitive thresholds, as it has never been adjusted for inflation. Also, taxing Social Security benefits is a double stealth tax. The inclusion of up to 85% of benefits in taxable income, besides increasing tax liability, might also increase marginal and long-term capital gains tax rates.

Other potential reasons might be increased Medicare Part B and D premiums, but also increased exposure to the net investment income tax.

Increased Medicare Part B and D premiums

Medicare Part B and D premiums are also determined by simply using modified adjusted gross income from the federal income tax return that was filed two years before the current year. Assuming you are willing to enroll in Medicare at 65 years old, you might want to project and track your MAGI every single year, starting at 63 years old.

Monthly premiums start at $148.50. An Income Related Monthly Adjustment Amount (IRMAA) might be added to this amount, as long as your income is higher than $88,000 for single taxpayers and $176,000 for joint tax filers.

Also, monthly premiums could be as high as $504.90 for those who are at the top income threshold, which results in an increased annual Medicare premium of $4,276.80 per person and $8,553.60 per couple.

It’s worth mentioning that Medicare Part B and Part D monthly premiums could increase a lot in a certain year, as long as a large amount of income was provided two years before that particular year.

Net investment income tax

The net investment income tax has been under the radar for many taxpayers since it was first introduced in 2013. The tax is a surtax that is usually paid by high-income taxpayers with larger investment incomes. Single taxpayers with investment income and MAGI bigger than $200,000 and married joint taxpayers with MAGI over $250,000 could be subject to a certain surtax of 3.8% on net investment income.

This could also include capital gains, interest, dividends, rental income, royalties, and nonqualified annuity income. The net investment income tax might increase the 15% and 20% long-term capital gains tax rates by 3.8% for all taxpayers who earn more.

Widow’s income tax penalty

The widower’s income tax is definitely the healthiest tax of them all, especially because people aren’t fully aware of it. Another reason might be that it’s a bit difficult to plan for it, and it might potentially increase tax liability year after year once it applies.

However, the income tax law doesn’t show kindness to surviving spouses who don’t want to remarry. A widow or widower who might have the same or less income could become the subject of a higher federal income tax liability.

This could result from the transition from married individuals filing at joint tax rates to single tax rates, plus a standard deduction of 50% of $25,100 (which is the amount filed by married individuals), which will start in the year that follows the year of the spouse’s death.

$10,000 limitation on your personal income tax deductions

As opposed to the first five stealth taxes that are directly increasing income tax or Medicare premiums, this one wants to achieve the same thing but indirectly. That $10,000 limitation on the personal income tax deduction manages to accomplish this by eliminating a wide amount of one’s overall tax deductions for those who are affected by it.

This could also translate to reduced itemized deductions of tens of thousands of dollars or more in many other cases since 2018. Along with this change comes doubling the standard deduction and reducing mortgage interest deductions, which drastically reduced the percentage of taxpayers who itemized their deductions from 31% before the enactment of the Tax Cuts and Jobs Act to 14% in 2019.

Opportunities: staged Roth IRA conversions

Even if other retirement income planning strategies could be implemented to address each of the six stealth taxes that were discussed in this article, there’s one particular strategy that might reduce the income tax liability to the first five, and that’s a multi-year Roth IRA conversion plan.

The current low historic income tax rates that might expire after 2025 and even sooner could provide a great opportunity for Roth IRA conversions that plenty of us might never see again. So if you’re currently in your 50s or 60s and you already have a traditional 401(k) plan, SEP-IRA, or traditional IRA, there’s no need to wait until you reach 72 years old.

If you try a staged Roth IRA conversion plan, you could eliminate taxation on the future growth of converted assets but also reduce the required minimum distributions starting at age 72. In turn, it will allow you to reduce your exposure to the first five stealth taxes.

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