It’s March, the NCAA tournament is quickly approaching, and many are playing a last-minute game of ‘bracketology,’ trying to create the perfect bracket. The odds of randomly picking a perfect bracket are pretty remote, like 2^63, or about 1 in 9.2 quintillion. Pretty tough odds. There’s another, and arguably more important, bracket you need to consider, your tax bracket. I never thought I’d say this, but tax law is a little simpler to understand. Let’s put the NCAA tournament aside and take a look at the nuances of tax-brackets.
Tax brackets are a very important consideration in financial planning, touching everything from Roth conversions to retirement planning. The thing is, many people are unaware of their actual tax bracket, and make planning decisions based on an incorrect assumption. Who is in a higher tax bracket? A 43-year-old, single, self-employed plumber making $125,000 a year in his business, or a couple of doctors with a practice in a Sub-S corporation making $300,000? The plumber pays 15.3% self-employment tax (of which half is deductible on his income taxes) and is likely in the 24% income tax bracket but gets a 20% deduction for his pass-through income. This puts him in an effective federal bracket of 33.03%, plus state taxes (until he gets to $147,000). Let’s say the doc couple take salaries from their practice of $75,000 each, and the rest as a distribution. They’d pay 7.65% FICA tax on their salaries and their practice would pay the same. However, the distribution would be Qualified Business Income, subject to a 20% deduction. Their top bracket is only 19.2% (up to $319,800). Complex? Absolutely.
Social Security Floors. Something a lot of retirees tend to miss are the ‘floors’ on certain income tax items, the most common being Social Security and Medicare. This can cause problems with IRA distributions and/or Roth conversions. With Social Security, none of the benefit is taxed if your Modified Adjusted Gross Income (MAGI) is less than $32,000 if married and $25,000 if single. MAGI is your Adjusted Gross Income plus nontaxable income plus ½ your Social Security Benefit. Thus, if John (63) and Anne (61) have pension income of $21,600, plus one social security benefit of $18,000, none of their benefit would be included in taxable income, since $21,600 plus $9,000 (½ of $18,000) is $30,600, less than $32,000. Because of the standard deduction of $25,900, they’d pay no taxes. Zero bracket.
However, as your MAGI goes up, the taxability changes significantly. If your MAGI is $32,000 – $44,000 (married) or $25,000 – $34,000 (single), 50% of your benefit is taxable. MAGI over $44,000 (married)and $34,000 (single), 85% of your benefit is taxable. If John and Anne took an IRA distribution of $20,000, it would seem they would only pay possibly a maximum of $2,000 (10% of $20,000). But the floor rears its ugly head, since now their MAGI is $50,600 ($21,600 pension plus $9,000 (half of Social Security) plus $20,000 of IRA). Their taxable income would be the $21,600 of pension, plus 85% of their Social Security, plus the $20,000 IRA. Taxable income is $56,900. Tax would be about $3,309 on the $20,000 IRA distribution, up from zero tax.
IRMAA: Medicare Floors. Another ugly bracket shifter is the Medicare B and D Premium income-related monthly adjusted amount, known as IRMAA. The IRMAA is sneaky since it goes back to your income tax return for two years prior. Thus, for 2022, it is based on your 2020 income and a special Modified Adjusted Gross Income. The IRMAA limits are recalculated annually, so what you do in 2022 can bite you in 2024. Here are the B and D limits for 2022:
Here’s what you need to know about IRMAA and your taxes
Medicare.gov
Thus, a big Roth conversion or IRA could not only cost income taxes in the year of the conversion or distribution but could cost significantly to Medicare two years later. Note the jumps aren’t linear: the increase is about 40% on the first tranche, 43% on the second tranche, then declines. Taking the IRMAA into account is important, especially if multiple years might be affected.
Pass-through Income. Another bracket-ology area is the Qualified Business Income (QBI) deduction for pass-though businesses. A ‘pass-through’ is any business except a C corporation and certain trusts and estates. Pass-throughs get a 20% deduction for Qualified Business Income. All pass-through businesses can use the deductions on taxable income up to $340,100 (married) or $170,050 (single). As you go over that limit, the deduction phases out as income goes up by $100,000 (married) or $50,000 (single). Businesses that are not ‘Specified Service Trade or Business’ can use the QBI on any income level. Specified Service Trade or Busines are people who provide professional services, like doctors, lawyers, CPAs, and so forth. Thus, if Melinda is a married dentist and the couple has taxable income of $300,000, they can use the QBI deductions. If they do Roth conversions or take large IRA distributions (more than $240,100), their bracket shoots from an effective 19.2% on the QBI to 33% or greater.
Bottom Line. In volatile times, Roth conversions and other tax planning strategies can be quite useful in mitigating issues with tax efficiency. It is important to play close attention to the actual tax bracket, including all payments, like IRMAA, Social Security and subtle changes like the QBI. Unlike the NCAA brackets, the odds of a perfect tax bracket are attainable at odds better than 1 in 9.2 quintillion. It might require some good number crunching, but it can sure pay off. As always, I’ll try to answer questions by e-mail: llabrecque@sequoia-financial.com.