Tax-deferred investments not only help clients grow retirement assets faster, they also may help clients reduce taxation on Social Security benefits and lower the cost of Medicare premiums.
To understand how this works, it’s important to remember that the degree to which Social Security benefits are taxed and the cost of Medicare premiums are both affected by taxable income.
- With taxable investments, such as mutual funds, clients have no control over when or how much dividend payments may increase their annual taxable income.
- With tax-deferred investments, earnings are not included in taxable income until a client chooses to withdraw them.
In other words, tax-deferred investments give clients greater control over their income and when taxes are applied. One advantage of deferral is that it can help clients stay below certain IRS thresholds, which, if exceeded, could cause taxation on Social Security benefits and increase the cost of Medicare premiums. To avoid exceeding those thresholds, clients with tax-deferred investments can choose not to withdraw from those investments or take a limited amount of withdrawals.
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How Much of My Social Security Benefit May Be Taxed?Use this calculator to determine how much of the Social Security benefit may be subject to income tax.
Controlling taxable income can also benefit clients who enroll in Medicare. The higher their modified adjusted gross income (MAGI), the greater Medicare premiums may be. In fact, depending on a client’s MAGI, Medicare Part B and Part D premiums are expenses that can increase by more than $500 per month for Part B and nearly $80 per month for Part D. Below are the 2022 MAGI thresholds affecting Medicare premiums.
| Individual Filers | Joint Filers | Monthly Premiums | |
|---|---|---|---|
| Part B | Part D1 | ||
| Up to $91,000 | Up to $182,000 | $170.10 | Plan Premium |
| $91,000 – $114,000 | $182,000 – $228,000 | $238.10 | Plan Premium + $12.40 |
| $114,000 – $142,000 | $228,000 – $284,000 | $340.20 | Plan Premium + $32.10 |
| $142,000 – $170,000 | $284,000 – $340,000 | $442.30 | Plan Premium + $51.70 |
| $170,000 - $500,000 | $340,000 - $750,000 | $544.30 | Plan Premium + $71.30 |
| More than $500,000 | More than $750,000 | $578.30 | Plan Premium + $77.90 |
Effective January 1, 2013, the Health Care Reform Act created tax increases that may impact certain high-income earners. These taxes include the “Medicare surtax”—a 0.9% increase to an already-existing payroll tax—and the Net Investment Income Tax (NIIT), a 3.8% federal tax on net investment income.
Both taxes are assessed only on taxpayers who exceed the modified adjusted gross income (MAGI) thresholds of $200,000 for single filers or $250,000 for married filing jointly. If these thresholds are not exceeded, the taxes do not apply. Keep in mind, these thresholds are not adjusted for inflation, so as inflation continues to increase an individual’s MAGI, more and more people could be subject to these taxes.
The Medicare surtax is 0.9%. It is assessed on wages and self-employment income in excess of the threshold amounts. This surtax is in addition to the existing payroll taxes, bringing the total payroll tax amounts to:
The Net Investment Income Tax applies if MAGI threshold amounts ($200,000/$250,000) are exceeded. If so, this 3.8% federal tax1 will be assessed on the lesser of:
- The amount by which a client's MAGI exceeds the threshold, which is called the MAGI Test. MAGI, for these purposes, is generally the adjusted gross income (AGI) plus any amounts previously excluded for foreign-earned income and foreign housing under Internal Revenue Code (IRC) Section 911.
- Net investment income, which includes taxable interest and dividends, long- and short-term capital gains, annuity income, passive rental income, and royalties. However, it does not include income from Social Security benefits or distributions from pensions and other retirement accounts (such as IRAs and Roth IRAs).
| Examples | Does the 3.8% Federal Tax Apply? | The Math |
|---|---|---|
Taxpayer #1
|
Yes | 1. MAGI Test 2. Lesser of Test Result: 3.8% is assessed on $10,000 = $380 |
Taxpayer #2
|
No | 1. MAGI Test 2. Lesser of Test Result: 3.8% is assessed on $0 = $0 |
Managing Net Investment Income
Increase Contributions to Retirement Accounts
Distributions from qualified plans, including 401(k) plans, 403(b) plans, IRAs, and eligible 457 plans, are not considered net investment income and not subject to the tax. Your clients could consider increasing contributions to these plans so that distributions from plan assets are free of the tax. Shifting wages to retirement plans will also reduce the MAGI and help clients stay below the MAGI thresholds.
Reminder: Distributions from these plans will still be included in the MAGI, and require clients to manage the distributions carefully to ensure the MAGI thresholds are not exceeded.
Use Deferred Annuities for Nonqualified Investments
Investments in an annuity are tax-deferred. Therefore, any earnings accrued in the contract are not recognized as net investment income until they are distributed. This means that instead of using an investment that results in capital gains tax, which is considered net investment income, clients may elect to use an annuity, which remains tax-deferred until distributions are taken. This may allow for more control of when net investment income would be assessed.
Reminder: Distributions from a deferred annuity will still be included in the MAGI, and require clients to manage the distributions carefully to ensure the MAGI thresholds are not exceeded.
Managing MAGI
Utilize Annuitization for Tax-Efficient Distributions
Distributions from a nonqualified single-premium immediate annuity (SPIA) or an annuitized deferred annuity receive exclusion ratio tax treatment. Because of the favorable tax treatment, a portion of the distribution is a return of basis, and income will be excluded from income tax.
Compare this to the last-in-first-out (LIFO) treatment annuity withdrawals generally receive during the deferral phase, where earnings are distributed first. Through taking income by annuitization, the tax liability is spread over an extended period and may result in a lower MAGI.
Reminder: Earnings from an annuitized contract are included in net investment income and MAGI. Although annuitization may help with keeping MAGI lower, careful planning will be needed to make sure reducing a taxpayer’s MAGI with this strategy does not come at the expense of exposure to the NIIT through an increase of net investment income.
Fund a Charitable Remainder Trust (CRT) or Charitable Lead Trust (CLT)
Clients can gift property into a CRT for an immediate charitable income-tax deduction based on the present value of the remaining interest in the asset gifted. The deduction can then be used to help offset income and reduce the client’s MAGI.
Reminder: During the trust term, the non-charitable beneficiary may receive an income, with only the remainder passing to the charity at the end of the trust term. This income may come in the form of an income stream that is included in the CRT income beneficiary’s MAGI.
Clients can also fund a CLT, where the charity receives the income and the remainder passes to the non-charitable beneficiary. In this case, the donor will receive a charitable income-tax deduction equal to the present value of the income transferred to the charity. Similar to using a CRT, funding a CLT can be used to reduce an individual’s MAGI.
Managing Both Net Investment Income and MAGI
Convert or Contribute to a Roth IRA for Future Tax-Free Distributions
Qualified distributions from Roth IRAs are not included in taxable income and do not increase a client’s MAGI. Distributions from Roth IRAs are excluded from net investment income resulting in an investment vehicle that can help reduce exposure to both factors used in the application of the 3.8% NIIT. Therefore, establishing a Roth IRA may help manage the tax increases from both sides when distributions begin.
Reminder: Converting to a Roth IRA is taxable and included in the client’s MAGI in the year of the conversion and can result in the MAGI thresholds being exceeded.
Consider Municipal Bonds as Investments
Income from municipal bonds is not considered net investment income, and is not generally considered when determining the MAGI thresholds. It might make sense to consider the use of municipal bonds in the client’s overall portfolio. This could result in a portion of the overall portfolio being removed from the 3.8% NIIT calculation.
A Word about Timing
Clients should pay close attention to the “timing” of recognizing income, which impacts the MAGI thresholds and the net investment income. Review your book of business for high-income-earning clients who are close to or may exceed the MAGI thresholds, and consider a few of the strategies here to help address planning issues around these taxes.
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The Power of Tax DeferralDiscover how powerful tax deferral can be in helping clients grow their assets, as demonstrated by three mathematical concepts. -
Asset Location Can Reduce TaxationA strategy for managing taxation to help clients reach long-term investment and savings goals. -
Uncover Opportunity: The Annual 1040 ReviewThe importance of annually reviewing a client's 1040 to uncover tax management and long-term planning opportunities. -
2022 Federal Tax Amounts and LimitsA quick-reference sheet of current federal tax amounts and limits.
The above is provided for informational purposes only and should not be construed as investment, tax, or legal advice. Information is based on current laws, which are subject to change at any time. Clients should consult with their accounting or tax professionals for guidance regarding their specific financial situations.
Under current law, a nonqualified annuity that is owned by an individual is generally entitled to tax deferral. IRAs and qualified plans – such as 401(k)s and 403(b)s – are already tax-deferred. Therefore, a deferred annuity should be used only to fund an IRA or qualified plan to benefit from the annuity's features other than tax deferral. These include lifetime income, death benefit options, and the ability to transfer among investment options without sales or withdrawal charges.
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