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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.

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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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Charlie Warner Jr
Charlie Warner Jr
2 months ago

Rick, thanks for donating your time to help those who are less fortunate. Yes, it is a bit complicated and that’s why I pay to have it done, and yes I feel blessed I can afford it.

William Perry
William Perry
2 months ago

In response to Dick Quinn’s query,about huge medical expenses for itemizing, my experience as a 70+ CPA who does still practice in tax, is the major OOP medical expenses fall in the categories of first – activities of daily living in assisted living or skilled nursing care where a LTC policy was not bought, was dropped because of premium increases or where inflation has made the an older LTC policy coverage inadequate , second – where a person went the traditional Medicare route but failed to buy a supplemental policy to cover the 20% expense copay that has no upper annual limit that a typical MA does have (and then has a major medical event) and third – uninsured dental expenses which can become crazy expensive.
For those without family or friends nearby or live in a rural area a trip that occurs by ambulance can have huge OOP expenses with the wrong insurance coverage.
I have seen certain cancer drugs for with a list price of $18K a month that even with great part D Rx coverage are difficult for average lifetime earners to come up with the a 5% monthly copay ($900 a month) for the eleven months after blowing through the coverage levels in the first month of the year.
As has been said and implied many times on Humble Dollar – please make the time to learn about your options in regards to Medicare and long term care coverage and the pitfalls as you approach age 65 or sooner. Yes, there is a special enrollment period after age 65 for those who continue to work for a large employer. If you want, but fail to sign up for traditional Medicare timely, you may find you are outside the period when buying a guaranteed supplemental policy is not possible.
For myself and my wife we chose traditional Medicare with a plan G supplemental plan and a preferred part D plan which for us is a higher premium but lower overall cost as we take some of the drugs you see advertised every night.
Unfortunately we both have had past medical events which preclude eligibility to now purchase LTC coverage. I now regret not choosing to buy LTC coverage. I was 40 and invincible, until I was not.
I continue to work for many reasons – one of which is access to employer vision & dental coverage.
I hope this motivates the readers to become better informed regarding Medicare so as to not run out of money before you run out of breath. Thanks Jonathan.

mjflack
mjflack
2 months ago

Good article! Foreign Tax Credit is a similar issue. $599 in foreign tax and you get a $599 credit. $601 and you after a convoluted formula you may get substantially less.

Jerry Pinkard
Jerry Pinkard
2 months ago

Good article. It is amazing how complicated tax filing has become. I have always been a DIY for taxes. I have a degree in accounting. Although I have never practiced as such, I understand the theory reasonably well. I finally began using TurboTax a few years ago and there is no way I will go back. There are so many ancillary schedules and forms to do. It simply is not worth investing the time to do it manually.
My son has a small business and I always do his taxes. I used to do those manually rather than pay TT to do it. No way anymore. It is incredible how many schedules and forms are required.
One of my accounting professors referred to the latest Federal tax simplification act as the tax preparers relief act of year xx. Each simplification effort seems to add thousands of pages to the tax regulations, further complicates tax preparation, and only benefits tax preparers, tax software companies and tax lawyers.

R Quinn
R Quinn
2 months ago

Richard, as life life-long Jersey resident and a family going back to around 1840, welcome to NJ. and it’s many zigs and zags. When they first introduced the pension exemption I was delighted – until I read the fine print.

I just looked and the difference between my federal marginal and effective tax rate is 14%, it would be more if not for those darn RMDs.

I would like to explore your comment, “But I’ve also seen firsthand how the expenses of retirees can increase sharply, especially if they have a medical issue.” That statement about medical is often repeated, but is it really accurate?

Yes, premiums can increase via IRMAA and Medigap adds a couple of hundred to premiums. However, combined they provide virtual total protection from the cost of the treatment of a medical issue.

For example, in the last couple of years my wife and I incurred medical bills of several hundred thousand dollars, but we paid just our Part B deductible. I paid my deductible in 2022 and if I have more expenses I won’t pay more OOP.

I admit there could be an exception for those taking certain medications, but the vast majority of most used Rxs are subject to modest co-pays.

In your experience what do you see most often as medical expenses affecting the retiree tax filers you help? Thanks

mytimetotravel
mytimetotravel
2 months ago
Reply to  R Quinn

Don’t be so quick to dismiss drug costs. Part D drug plans help, but only so much. My drug costs last year were $6,000, with a Part D plan, and I don’t see them decreasing. I worry that my drug plan will drop my medication from the formulary and I certainly can’t afford it on my own. (Retail is over $5,000 a month, up from $2,000 in 2013.) The condition I am treating is not that uncommon. My understanding is that Medicare Advantage plans have similar coverage to Part D plans. The discussion of long term care costs is also on point – I am moving to a CCRC partly because it will not throw me out if I run out of money, but it will not be cheap.

R Quinn
R Quinn
2 months ago
Reply to  mytimetotravel

I don’t dismiss what can happen with prescription costs. I know first hand from friends what can happen. But the reality is that only about 3% of Part D enrollees ever reach the catastrophic level in a given year. Of course that is little comfort for those who do. LTC is a whole other ball game with few options for many. Even insurers are getting out of the business.

mytimetotravel
mytimetotravel
2 months ago
Reply to  R Quinn

I imagine a lot of Medicare beneficiaries can’t afford to reach catastrophic coverage. My drug costs were “only” $6,000 last year because I take a brand name drug and manufacturer subsidies count towards reaching the top of the coverage gap. Someone taking generics would spend $7,050 this year to reach catastrophic coverage. And then they would pay 5%, which may sound like a bargain, but not if the drug is expensive.

Rick Connor
Rick Connor
2 months ago
Reply to  R Quinn

Richard, thanks for the comments and welcome to NJ. I should have been clearer that the medical conditions I’m referring to are not the everyday doctors, prescriptions, or even hospital stays that Medicare, and a Medical-gap plan cover well. My Father incurred enormous medical expenses in his last 5 years. My Mom used extensive medical care in her last 7 months, fighting brain cancer. In both cases Medicare and a Medi-gap policy covered the vast majority of their costs. We did have to fight pretty hard for some Dr. recommended therapy at one point for Mom.

I’ve had a fair amount of experience with severe medical situations that create the need for expensive long term care. For example, my mother-in-law, in he early 80s, had emergency surgery and suffered immediate cognitive changes that required a long term care facility with both memory care and wound care expertise. There were very few facilities that could handle it and they were expensive. Her monthly expenses increased dramatically. Because of her dementia diagnosis, the majority of here expenses were medial deductions (over $70K the first year). We were able to use those deductions to withdraw additional funds from her modest IRA without federal tax, and years later realize LTCGs at 0%. In her case we built a plan that

A good friend’s wife developed early onset dementia and deteriorated rapidly and required expensive care. Sadly she died within a year of entering the facility. I have another friend who’s Mom languished with Alzheimers in an expensive facility for a decade. His dad had LT care insurance, but it was a three year policy.

I’m sure it’s my age, but it seems everywhere I look I see a friend or former co-worker who has someone in their family that requires expensive LT care. I’m sure many readers have the same experience. I think when you deal with that kind of situation in the decades leading to retirement, it colors your view of how to plan for your retirement.

With regard to NJ taxes, I’m currently trying to figure out the Property Tax Refund provisions – the tax freeze, Homestead benefits, and PT deduction. It’s different for homeowners, renters, and – new to me – retirees who own mobile homes or RVs and pay a monthly rent for a lot in a park. Certain municipalities take the homestead benefit and apply it directly to a tax bill, others send the check to the homeowner. And NJ still applies the shared responsibility tax to those who don’t have medical insurance even though the fed govt got rid of it. It sound like I’m complaining, but I actually enjoy learning and figuring out this tangled mess!

R Quinn
R Quinn
2 months ago
Reply to  Rick Connor

I find the property tax freeze particularly fascinating. Why should a person with an income of  up to $94,178 have their property taxes frozen just because they are age 65 while the tax burden is shifted to young families earning far less?

Paula Karabelias
Paula Karabelias
2 months ago
Reply to  R Quinn

I’m aware of several people who have Medicare Advantage , didn’t understand their policies, (or much at all about Medicare)and were unprepared for the out of pocket expenses when they developed a chronic illness. Unfortunately, most of them are of modest means . Those who could switched to original Medicare with Medigap and a drug plan.

R Quinn
R Quinn
2 months ago

Yup, it’s complicated, too complicated and many people are fooled by those enticing MA ads.

Paula Karabelias
Paula Karabelias
2 months ago
Reply to  R Quinn

Absolutely ! And in some cases agents who are a bit biased because the commissions are higher for Med Advantage . A friend of mine , a college educated former HR manager , went to an agent who never discussed the two ways to obtain Medicare . She gave my friend a policy , which turned out to be Medicare Advantage when I looked at it. My friend had no idea what she had. I advised her to change it and also to sit down with a SHIP counselor for unbiased and free advice. She now has original Medicare with Medigap.

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