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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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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.
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.
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.
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.
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