Shadow Taxes

Episode #14: Shadow Taxes

Hello and welcome to another episode of the Retired-ish podcast, I’m your host Cameron Valadez and in this episode, I’m going to teach you about common taxes that many people pay even though sometimes they don’t have to. This is mainly due to the fact that these are taxes that are hard to notice and sometimes impossible to see coming, I call them shadow taxes.

You don’t need to become a master in tax or finance to avoid paying these taxes, you just need to be aware of a few concepts and know what to look out for. Then, if you spot one of these potential tax issues in your situation, you can call in the professionals for help. But if you don’t even know what you’re looking for, you’re likely to continue sharing more and more of your hard-earned money with the IRS and potentially state governments.

One primary reason why so many people pay these shadow taxes is that they continue to look in the rearview mirror rather than forward through the windshield. And no not literally, but what I really mean is that people only think about taxes year-to-year come tax time. We get our taxes done for the previous year and then don’t think about them again until we see the next ad for do-it-yourself tax software during next year’s Super Bowl!

We often see solutions like that as an “easy button” for taxes and tell ourselves that it will solve all our tax problems and it will do everything for us, tell us what we have to pay, and that’s that – when in fact, that’s often not the case. But again, this is what happens when all we do is look in the rearview mirror. What happens when you continuously drive while looking in the rearview mirror? You get in a lot of accidents…

So why do people avoid doing things that can help them pay less than they need to in taxes? Because taxes are complicated and overwhelming, it’s also likely they just weren’t aware of the things they can do. But using that as YOUR excuse is merely a choice, one that hopefully, I can help you change…

Taxes don’t need to be so overwhelming. In fact, they get less and less overwhelming when you begin to look through the windshield and start tax planning – this means looking forward and doing things now that will allow you to pay less in taxes in future years over the rest of your lifetime, and to structure your situation so that you will never be caught off-guard paying more than you need to when life happens.

So to make it easy on you, I’m going to teach you about some of the more common taxes you don’t see, and how to reduce or potentially avoid them, legally of course. So sit back and listen in.

First things first, how can you find some of the shadow taxes you pay, and what are the most common ones that are paid even by those with just modest incomes?

If you want, you can find a pretty expansive list of many of the hidden taxes on what is called Schedule 2 of the 1040 which is also labeled “additional taxes”. The 1040 is the main official document that taxpayers in the US use to file their taxes. When you do your taxes, it’s the couple of pages that summarize everything and tells you your tax liability. On that schedule 2, there are over 2 dozen additional taxes that most people don’t see, until they incur one of them of course.

It’s important to know that Schedule 2 includes most of the hidden shadow taxes, but not all of them. There are many that don’t necessarily show up on a tax return in plain English as additional taxes paid.

In either case, some of the most common shadow taxes we see people pay are:

• The repayment of advanced excess Premium Tax Credit – I know that sounds really complicated but bear with me, I’ll explain in a minute.
• The Net Investment Income Tax (or NIIT for short)
• Medicare IRMAA Surcharges on Medicare Part B & D Premiums (IRMAA stands for Income-Related Monthly Adjustment Amount)
• And Additional Taxes Owed on Social Security

There are some other shadow taxes such as the permanent Medicare premium penalties from not enrolling on time as well as underpayment penalties but we will save those for another episode.

Let’s start with the repayment of excess Advanced Premium Tax Credit.

The Premium Tax Credit or PTC for short is a tax credit available for some who obtain health insurance coverage through the nation’s Health Insurance Marketplace. This program may go by other names depending on the state in which you live - for example in CA it’s called Covered California. So just to be clear, this credit is not available to everyone.

In order to qualify, not only do you need to have coverage through the marketplace but you must also meet a few other rules. The most notable is that you must fall within a certain range of “adjusted gross income” which is a figure that can be found on your 1040 tax form I mentioned earlier. There are a lot of nuances to this credit but at a high level, the income thresholds are between 100 and 400% of the poverty line in your state. That being said this credit differs depending on your resident state. Eligibility will also depend on all of your and your spouses’ healthcare coverage options.

This credit is frequently paid in advance. You normally receive the credit throughout the year, rather than at tax time the following year like a lot of other tax credits. Most of the time, when you purchase a health insurance policy through the marketplace, they will have you verify your income and will tell you whether or not you qualify and if so, will simply reduce your premium payment to the insurance company. Therefore, the credits oftentimes come in the form of reduced premiums.

One important aspect of this credit is that after the year 2022 if your income is over the top-end income limit which again is 400% of the poverty line, you lose the entire credit. So if your income in a given year ends up being 401%, you will suddenly lose the credit in that year. This can be a HUGE surprise come tax time since you’ll now have to REPAY the credit you received in advance throughout the previous year!

For some tax payers, this can be tens of thousands of dollars PER YEAR!

If you are insured through the marketplace, you’ll receive a tax form 1095-A from the insurance company that you’ll want to keep and provide to your tax preparer come tax time. This reports the information you will need to potentially claim the credit.

If you want to know whether or not you are currently getting this tax credit, look for tax form 8962 in your latest completed tax return. If you don’t see it, you did not receive the credit.

So how can this be a shadow tax? Well, if you are going to be benefiting from this tax credit, and you and/or your financial advisor do something that causes your income to go over the income thresholds, you’re likely to have a big surprise come tax time – and nobody wants this of course.

Some examples might be:

• Recognizing large capital gains in non-retirement accounts
• Accelerating spending from retirement accounts
• Doing Roth Conversions
• Or Selling Real Estate with capital gains

While some of these strategies might be worthwhile in the long term, you and your advisors will want to be extra careful regarding the timing and other ramifications such as the PTC. Again, these strategies may provide value in and of themselves but if they cause issues with your PTC credit, the taxes owed can completely wipe out any benefits from those strategies.

Now you may think “ah this won’t affect me because I don’t get this credit anyways”. Not so fast… You’d be surprised how many people think that but then end up retiring before age 65 (which is when you’re typically Medicare eligible) and then need to go to the marketplace for coverage. Then they realize their income after retiring is low enough that they now qualify. Always be planning ahead…

As I have said before, this kind of thing is just one more reason why your financial advisors should be reviewing your ENTIRE tax return and working closely with your tax professional when making planning recommendations. Sorry, but if they’ve never asked you for your tax return, you may want to rethink your strategy and team, or you could be paying more taxes than you needed to.

Now let’s go over the infamous Net Investment Income Tax or NIIT for short.

This is essentially an extra 3.8% in taxes on investment income, which is typically added to any capital gains you might pay in a given year. This includes short-term and long-term capital gains. Remember from previous episodes that short-term capital gains are taxed at ordinary income tax rates that get almost as high as 40%. Therefore, depending on your specific tax bracket, if you end up owing the Net Investment Income Tax, you could pay over 40% in taxes on short-term gains in federal taxes alone in a given year!

This tax was added after the passage of the Affordable Care Act and is one that many high-income tax payers pay, usually without knowing. However, you may also pay this tax unexpectedly by making certain decisions that boost your income in any given year, just as with those in my last example.

As the name partially suggests, this is for taxpayers with some sort of investment income, this could be in addition to other income from a job, business, etc. The tax only applies to those with investment income AND whose “modified adjusted gross income” is above a certain threshold. These thresholds are currently $250,000 for those filing married filing jointly or as a qualifying widower, $200,000 for those filing single and head of household, and $125,000 for those filing married filing separately.

So what is included in investment income? For the purposes of the Net Investment Income Tax, the types of income included are:

• Dividends
• Taxable Interest
• Certain Annuities
• Rental Property Income
• Royalties
• Stock Options
• Passive S-Corporation income
• Passive Partnership Income
• And Trusts along with any potential capital gains as I mentioned before.

If you are over the income thresholds but don’t have any investment income, you won’t be subject to this tax. However, that may change one day, so don’t ignore this tax.

So how does the calculation work in general?

The tax is imposed on the LOWER of your TOTAL investment income OR the amount in which you go over the previously mentioned threshold.

So here’s an example:

Scott and Katie are married and file a joint tax return, they have $150,000 in wages, $20,000 in dividend income from their non-retirement account, $10,000 in interest income from a large CD, and $80,000 in capital gains in their non-retirement account from a combination of mutual fund capital gains distributions and sales of securities at a long-term capital gain. This brings them to a total of $260,000 in income, which for simplicity’s sake is also their modified adjusted gross income.

While they have $110,000 in investment income from interest, dividends, and capital gains, they would only pay the 3.8% Net Investment Income Tax on $10,000. Why? Because their income only went over the threshold of $250,000 by $10,000 and the tax is based on the LOWER of that number or the investment income which was $110,000.

In contrast to some other shadow taxes such as the excess PTC credits and Medicare IRMAA surcharges that you’ll learn about next, the NIIT is a progressive tax and not subject to a cliff. For example, you only owe the extra 3.8% on the amount you go over the previously mentioned limits, in other words, if you go over the income thresholds you won’t pay the extra 3.8% on all of your income.

Okay now it’s time for the absolute most common shadow tax particularly for pre-retirees and retirees. And that is the Medicare Income-Related Monthly Adjustment Amount Surcharge, otherwise known as IRMAA. This isn’t recognized as a tax by most people since it is a surcharge on Medicare premiums, but I would argue that anything that penalizes you based on certain income thresholds and paid to any government-related organization is a tax. This is also not something you will find on a tax return.

IRMAA is a surcharge that is automatically tacked onto your Medicare Part B and D premiums again depending on your modified adjusted gross income or MAGI for short. There’s that term again, hopefully, you’re seeing a pattern developing and realizing that this will be an important number to control if possible.

So how do you know what surcharges you might pay? Well just like with most of the other taxes we’ve discussed, there are different income brackets that will determine what the extra cost is, and this is per person. So if you’re married and both paying for Medicare, double it… I will include our Important Numbers Chart for 2023 in today’s show notes that will show you these IRMAA brackets.

For reference, the difference between the base premium for Part B which is essentially $165 in 2023, and the highest amount possible when adding the largest surcharge amount is around 3.5x bigger! So if you are married and in the highest IRMAA bracket, this could be the difference in paying a total of around $4,000 per year, compared to $14,000 per year, and again that’s not including the Part D surcharges. That can equate to another $10,000/ year or more in taxes - Not ideal.

Now for some people, this may be impossible to avoid if they have consistently high income in their retirement years. However, for others, it can be manageable or avoided completely. As I mentioned earlier, this tax is not progressive, it’s a cliff, therefore if you go over the first IRMAA income bracket threshold by just one single dollar, you will owe the additional taxes on all premiums for that year. This is why this tax is particularly dangerous, and additional care must be taken when planning ahead.

There’s one more nuance that makes this the sneakiest of shadow taxes, and that is that the income the IRMAA surcharges are based on is from your modified adjusted gross income from 2 years prior…

Say what? Yes, the current year’s surcharge will be based on your income from 2 years ago. This is why most are caught by surprise. You get a cute letter in the mail that says your Medicare premiums are being adjusted, even if you retire and have far lower income than while you were working.

However, in a lot of cases not all hope is lost, you can actually fight back and appeal that letter you receive. Now I won’t dive too much into an IRMAA appeal in this episode, but just know that it is possible and they do approve them often if you fill out your forms correctly and have a legitimate reason for appealing. There are currently 7 possible reasons and they are:

• Death of a Spouse
• Marriage
• Divorce or Annulment
• Work Reduction
• Work Stoppage
• Loss of Income from Income Producing Property
• And Loss or Reduction of Certain Kinds of Pension Income

And hey guess what, the worst that can happen when appealing is “No”.

Okay so even if you are one of those taxpayers that just can’t reduce your income low enough to avoid Medicare surcharges or are certain you won’t be able to once you get on Medicare, you’ll still want to plan ahead and know when and how IRMAA will affect you. This way you can plan appropriately for your retirement income needs.

On the flip side, if you are under the IRMAA thresholds, you’ll still want to be mindful of how other strategies can cause you to incur this tax. Specifically, anything that will cause you to go just $1 over a threshold such as making large retirement account withdrawals, Roth conversions, or selling assets with capital gains. All of these things can cause you to pay this additional tax 2 years later! Therefore, you’ll want to be extra careful when doing your financial planning. I’ll say it again, this is yet another reason why it’s so important that you and your trusted professionals analyze your tax situation each and every year! Otherwise, you may pay taxes you shouldn’t have.

Now let’s look at another hidden tax that catches many retirees off guard which essentially boils down to the way or method in which Social Security is taxed. I like to call this phenomenon the “Social Security Tax Torpedo”.

Once you and/or your spouse start collecting your Social Security benefits, you will be taxed on those benefits by the federal government and possibly your state – some states tax Social Security while others don’t. However, the actual amount of your benefit that is taxed varies depending on your other income sources such as your wages, self-employment, interest, dividends, etc.

There are 3 parameters that the taxes on your benefits can be based on: None of your benefits may be subject to fed taxes if you have little to no other income other than Social Security. 50% of your benefits may be subject to taxes at your applicable tax rate, or up to 85% of your benefit may be subject to tax.

Notice that I am saying SUBJECT to tax. This means for example that if you have a $1,000/mo benefit, the most that can be subject to taxes is $850 which is 85% of your benefit. Therefore, you will pay taxes on that $850 rather than the full $1,000. So, if you’re in the 10% tax bracket, you would theoretically pay $85 in taxes on your $1,000 benefit.

The actual calculations are slightly more complicated but in general, single individuals with combined income from all sources from $25,000 to $34,000 and married filing jointly with combined income of $32,000 to $44,000 may be taxed on up to 50% of their Social Security benefits. If your income goes above those ranges, you may be taxed on up to 85% of your Social Security benefits. Note that these rules only affect the tax calculation on your Social Security benefits and do not change how you pay tax on any other income.

I will refrain from providing a specific example since the actual calculation is a little too complicated but just know that if you get hit by the Social Security Tax Torpedo, the effects can be dramatic! As you can tell, this phenomenon can affect those with just very modest incomes. I have seen some situations where someone was paying 22% in income taxes on their benefits and then all of a sudden pay over 40% in taxes on their benefits!

How does this happen exactly? Well, it happens like most of the other shadow taxes where you do something in a given year or series of years where you have increased income from other sources such as the sale of property or securities at a gain, making retirement account withdrawals, drastically increasing rental rates on your rental property, your depreciation deduction goes away on your rental property, investing in high income paying securities in non-retirement accounts, having a randomly large capital gain distribution from mutual funds held inside a non-retirement account, the list goes on. All of these things cause your other income to go up which in turn will affect the amount of your Social Security is taxed. See today’s show notes for a checklist of issues to consider as it relates to your Social Security Benefits. And as a side note, always consult your tax professional first before making any financial decisions that you think may affect your tax situation

Okay so now that we’ve learned about some of the most common shadow taxes, what are some other ways you might be able to avoid or reduce these taxes?

Well, if you recall, we mentioned that a lot of these taxes are based on income thresholds, a lot of them based on your adjusted gross income or AGI for short. Then there are some small adjustments to add to that figure to come up with your modified adjusted gross income or MAGI for short, which has a different definition for each different tax.

You aren’t expected to remember the differences, it’s too much, and the tax code is complicated. You just need to be aware that these taxes exist, and you’re likely paying them now, or will at some point in the future unless you do something about it.

So, one place to start would be to reduce those AGI and MAGI figures. There are numerous ways to do so, many of which I talk about in various episodes of the podcast. One example might be tax-loss harvesting when markets are down in non-retirement accounts, I’ll put a link to that previous episode in this episode’s show notes. Another might be to change the way you invest and utilize asset location, which is where you put investments that generate income on a regular basis to tax-deferred accounts like retirement accounts and leave the more tax-efficient investments in non-retirement accounts. Lastly one of the best things you can do is simply to PLAN AHEAD.

If you start doing some comprehensive financial planning, you may be able to see this coming and can start acting now so you don’t run into these issues later when they may be unfixable. An example of planning ahead might be that you utilize strategies such as Roth conversions BEFORE you start collecting Social Security so that when you need to take money from your retirement accounts to supplement your Social Security income later in life, you don’t increase your taxable income, which then will increase the amount of taxes you pay on your Social Security! At that same time, you may keep your income low enough that you avoid those pesky and expensive IRMAA surcharges! See how that works?

When looking at your entire financial picture and understanding how everything works together, you can make decisions that will allow you to reduce or avoid unnecessary shadow taxes and keep more of your hard-earned money.

That’s all for today’s show! As I mentioned, check today’s show notes for some helpful guides we’ve created to help you identify these hidden taxes. And while this wasn’t an all-encompassing list of hidden shadow taxes, hopefully you’re now aware of how to spot the more common ones that may be lurking in your future.
If managing all of these potential issues on your own is too daunting or time-consuming, don’t be afraid to reach out to knowledgeable professionals to delegate these responsibilities of your life to. You’ll likely get even more value from other additional tax, investment, and time-saving tips and advice.

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