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Life on the Margins

Richard Connor

THIS IS MY FOURTH year serving in AARP Foundation’s TaxAide program. I prepare federal and state tax returns three days a week for a mixture of retirees and lower-income citizens.

Each week, I see clients who are baffled by the complexity of our tax code. Many have been paying hundreds of dollars to commercial preparers because they’re afraid of making a mistake.

And no wonder. The federal tax code has myriad twists and turns that can confound the average taxpayer. Phaseout ranges and tax cliffs are common, so even a small increase in income can trigger a tax that folks weren’t expecting or prevent them from obtaining a credit or deduction that they thought they’d qualify for.

The Tax Policy Center has a useful article describing common phaseouts and their tendency to raise taxes on higher incomes. It groups phaseouts into three categories: family benefits, education and retirement savings. Within the first group are the widely used earned income tax credit, child tax credit, and child and dependent care credit.

With a phaseout, a tax benefit tends to get whittled away in stages as income rises. But some phaseouts are more like cliffs—the benefit disappears in big chunks as a result of a relatively small change in income. One example of a cliff is Medicare’s income-related monthly adjustment amount, or IRMAA.

In 2022, the premium for Medicare Part B insurance is $170.10 per month for a single filer with a modified adjusted gross income of $91,000 or less. With just $1 more of income, however, the premium jumps to $238.10 a month. That single dollar of extra income could cost a Medicare recipient $816 in 2022.

The severity of a cliff is often measured by its marginal tax rate, which is the tax rate on the last additional dollar of income. Continuing our IRMAA example, that $1 more in earnings could create a marginal tax rate of 81,600%. It may sound absurd, but you can find examples like this throughout the tax code.

As a new resident of New Jersey, I’ve been introduced to one of the steepest cliffs I’ve ever seen. New Jersey doesn’t tax Social Security or military pensions. But other retirement income—pensions, annuities and IRA withdrawals—can be taxed depending on income. For married filers, if your total income is $100,000 or less, none of your retirement income gets taxed by the state. Earn $1 more, though, and half that retirement income is subject to a state tax, potentially costing married filers $805. At $150,001 and above, 100% of joint filers’ allowable retirement income is taxable, potentially costing them an additional $2,072 in taxes and bringing their total tax bill to $5,512. At that level, that extra $1 in income has an incredible marginal tax rate of 207,200%.

Now, I understand that marginal tax rates need to be taken with a grain of salt. The effective tax rate represents a more realistic view of the burden that a New Jersey taxpayer shoulders. At a total income of $150,001, the effective state tax rate is still less than 4%.

Lest readers think I’m a tax crank, I understand that paying taxes is an important part of our civic duty. My wife and I are scrupulously honest in our tax filings and faithfully pay our taxes.

But I’ve also seen firsthand how the expenses of retirees can increase sharply, especially if they have a medical issue. Proper tax planning can prolong the life of a retiree’s savings by years. But it requires taking the time to understand the intricacies of the tax code—a tall order for many—or finding competent help from a paid or volunteer tax preparer.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.

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