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A Spike in Income during Retirement May Cause a Big Tax Surprise

Periodically you may need a large influx of cash to remodel your home, pay for a child’s wedding, help a grandchild with tuition or process a Roth IRA conversion.   Before pulling a big chunk of money from your retirement account or highly appreciated stock funds, consider the tax consequences.  You may anticipate normal income taxes on distributions from retirement accounts and capital gains taxes on the sale of stock but there are some additional costs you might not haven’t considered.

In the United States we have a progressive tax system where higher income earners pay a greater percentage of tax on their income than lower income earners.  As your income increases your tax rate increases.   In addition to increases in your tax rate, retirees incur three additional taxes/expenses when they reach certain income thresholds.  These include taxation on a larger portion of your Social Security benefit, the 3.8 percent Medicare surtax on net investment income and an increase in Medicare premiums.

The portion of your Social Security benefit that is taxable depends on your income level.    You will pay taxes on up to 50 percent if your benefit if your income is between $25,000 and $34,000 and you file individually or between $32,000 and $44,000 if you file jointly.  You will be taxed on up to 85 percent of your benefit if your income is more than $34,000 and you file individually or more than $44,000 if you file jointly.  The maximum anyone pays is 85 percent.   Income includes your adjusted gross income plus nontaxable interest income and half of your Social Security benefit.   

 Capital gains tax rates also increase as income rises.  The current rates are 0, 15 and 20 percent depending on income.   In addition to the capital gains tax, higher income taxpayers are subject to a Medicare surtax of 3.8 percent, implemented as part of the Affordable Care Act of 2010.   A Medicare surtax of 3.8 percent is levied on the lesser of net investment income or modified adjusted gross income (MAGI) of over $200,000 for individuals and $250,000 for joint filers.   

Finally, if you are married filing jointly and your MAGI exceeds $170,000 or if you file individually and your MAGI exceeds $85,000, you will have to pay higher Medicare Premiums.   Higher income recipients of Medicare will pay higher premiums for Medicare Part B (medical insurance) and Medicare prescription drug coverage depending on income.   The government pays about 75% of the Part B premium and the majority of the prescription drug coverage.  Higher income recipients are required to pay a larger percentage of the cost depending on income.

If you anticipate needing a large amount of cash from your retirement or investment accounts,  plan ahead and consider spreading the withdrawal over a few years to avoid hitting income thresholds that will result in higher taxes and higher Medicare premiums.