Ever since Social Security benefits became partially taxable in 1983, means testing has been a fact of life for high-income retirees. Strictly speaking, the taxation of Social Security benefits is not a means test. The dictionary defines a means test as "an examination into the financial state of a person to determine eligibility for public assistance." In other words, a means test determines whether or not you get a particular benefit, not whether it's taxed.
But the term "means testing" has become part of the current lexicon, referring to taxes and surcharges paid by higher-income Social Security and Medicare beneficiaries. These taxes and surcharges have escalated over the years and are likely to rise further as the nation deals with the deficit. And, because income thresholds are not adjusted for inflation, even moderate-income retirees are paying more for benefits that used to come without strings.
Income tax on Social Security benefits
The income tax on Social Security benefits was first imposed in 1984 following the Social Security Amendments of 1983. For the first time, individuals with incomes over $25,000 and couples with combined incomes over $32,000 were required to report up to 50% of their Social Security benefits as taxable income. In 1993, the Omnibus Budget Reconciliation Act imposed a second tier of tax, requiring single retirees with incomes above $34,000 and couples with combined incomes over $44,000 to report up to 85% of benefits as taxable income. These income thresholds were never adjusted for inflation.
But the term "means testing" has become part of the current lexicon, referring to taxes and surcharges paid by higher-income Social Security and Medicare beneficiaries. These taxes and surcharges have escalated over the years and are likely to rise further as the nation deals with the deficit. And, because income thresholds are not adjusted for inflation, even moderate-income retirees are paying more for benefits that used to come without strings.
Income tax on Social Security benefits
The income tax on Social Security benefits was first imposed in 1984 following the Social Security Amendments of 1983. For the first time, individuals with incomes over $25,000 and couples with combined incomes over $32,000 were required to report up to 50% of their Social Security benefits as taxable income. In 1993, the Omnibus Budget Reconciliation Act imposed a second tier of tax, requiring single retirees with incomes above $34,000 and couples with combined incomes over $44,000 to report up to 85% of benefits as taxable income. These income thresholds were never adjusted for inflation.
Income Tax on Social Security Benefits | ||
Filing status | AGI + provisional income* | Amount of Social Security subject to tax |
Married filing jointly | Under $32,000 $32,000 - $44,000 Over $44,000 | 0 50% 85% |
Single, head of household, qualifying widow(er), married filing separately and living apart from spouse | Under $25,000 $25,000 - $34,000 Over $34,000 | 0 50% 85% |
Married filing separately and living with spouse | Over $0 | 85% |
*Provisional income = one-half of Social Security benefits + tax-exempt income | ||
Income tax on benefits is a small but growing source of revenue for the Social Security trust fund, rising from $2.8 billion in 1984 to $22 billion in 2010.
Income-related adjustment on Medicare premiums
The Medicare Modernization Act of 2003 established an income-related adjustment for Part B Medicare premiums starting in 2007. There is no cap on these adjustments. Medicare Part B premiums are based on actual Medicare costs, with the federal government paying 75% and Medicare beneficiaries paying the rest, proportional to their incomes. As Medicare costs rise, premiums rise for all.
In 2010 and 2011, when the increase in Medicare premiums exceeded the Social Security cost-of-living adjustment, most Social Security recipients escaped the higher premium because of a hold-harmless provision that prohibited checks from being reduced if the COLA did not offset the Medicare premium increase. As a result, their share was shifted to higher-income beneficiaries.
Starting in 2011, the Affordable Care Act imposed an income-related adjustment on Part D premiums; this is paid to Medicare on top of any premiums paid to private insurers for drug coverage. Until now, the income thresholds have been adjusted for inflation; however, going forward the Affordable Care Act freezes the income thresholds through 2019.
2011 Medicare Premiums for High-Income Taxpayers | |||
MAGI Single | MAGI Joint | Part B premium | Part D income-related adjustment |
$85,000 or less | $170,000 or less | $115.40* | $0 |
85,001 ? 107,000 | 170,000 ? 214,000 | $161.50 | $12.00 |
107,001 ? 160,000 | 214,001 ? 320,000 | $230.70 | $31.10 |
160,001 ? 213,000 | 320,001 ? 428,000 | $299.90 | $50.10 |
More than 213,000 | More than 428,000 | $369.10 | $69.10 |
*Unless subject to the hold harmless provision | |||
Planning ahead
An important part of retirement income planning is arranging finances to avoid or minimize unnecessary taxes and Medicare surcharges. Because these income levels are not adjusted for inflation, more people will become subject to them as they seek more income from asset withdrawals or employment to keep up with rising living costs. So one of the first things I can recommend is that you work on the expense side and try to arrange for lower living costs in retirement. This may be done by paying down debt, downsizing your living situation, and switching to less expensive (but perhaps more fulfilling) hobbies and interests.
Then comes the hard part: determining how to tap sources of income in retirement to minimize taxes and surcharges. Without proper planning, you may be forced to receive taxable income that you don't need for living expenses yet pushes you into one of the Social Security tax or Medicare surcharge brackets. And keep in mind that these taxes and surcharges will become more burdensome in the years ahead due to the lack of inflation adjustments and the possibility of new means testing programs being imposed in the future.
Then comes the hard part: determining how to tap sources of income in retirement to minimize taxes and surcharges. Without proper planning, you may be forced to receive taxable income that you don't need for living expenses yet pushes you into one of the Social Security tax or Medicare surcharge brackets. And keep in mind that these taxes and surcharges will become more burdensome in the years ahead due to the lack of inflation adjustments and the possibility of new means testing programs being imposed in the future.
Because means testing programs are based on adjusted gross income, tax deductions won't help. You either have to take advantage of one of the few adjustments to gross income, such as retirement plan contributions, or keep income from ever being reported.
If you have lots of assets in IRAs and taxable investment accounts are asking for trouble. As the IRA assets appreciate, the RMDs will grow ever larger, and if the taxable investments aren't managed in a tax-sensitive manner, they will throw off annual taxable income. Consider converting all or part of the IRAs to Roth IRAs. And make sure whoever is managing the taxable investments is instructed to manage the taxes as well. Or consider buying an annuity. The Roth conversion may be a hard pill to swallow because it will generate a bump in taxable income and may cause Medicare premiums to jump two years later. Roth conversions done in 2011 and reported in 2012 affect Medicare premiums in 2014. But then it's clear sailing after that, as you may no longer be subject to RMDs and may take any amount of tax-free income out of the Roth.
Means testing is here to stay, and most aren't really aware of how it will affect them in the future. Your accounts probably are not set up to minimize taxable income, especially those retirees who dumped a large lump sum in an IRA hoping to avoid taxes on the distribution, only to find later on that RMDs will come back to bite them with higher taxes and higher Medicare premiums. By starting to work on these items early, you can do a thoughtful, gradual shifting of assets and strategies to help you take advantage of the few ways to escape the burden of means testing.
If you have lots of assets in IRAs and taxable investment accounts are asking for trouble. As the IRA assets appreciate, the RMDs will grow ever larger, and if the taxable investments aren't managed in a tax-sensitive manner, they will throw off annual taxable income. Consider converting all or part of the IRAs to Roth IRAs. And make sure whoever is managing the taxable investments is instructed to manage the taxes as well. Or consider buying an annuity. The Roth conversion may be a hard pill to swallow because it will generate a bump in taxable income and may cause Medicare premiums to jump two years later. Roth conversions done in 2011 and reported in 2012 affect Medicare premiums in 2014. But then it's clear sailing after that, as you may no longer be subject to RMDs and may take any amount of tax-free income out of the Roth.
Means testing is here to stay, and most aren't really aware of how it will affect them in the future. Your accounts probably are not set up to minimize taxable income, especially those retirees who dumped a large lump sum in an IRA hoping to avoid taxes on the distribution, only to find later on that RMDs will come back to bite them with higher taxes and higher Medicare premiums. By starting to work on these items early, you can do a thoughtful, gradual shifting of assets and strategies to help you take advantage of the few ways to escape the burden of means testing.
