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Beware of the ‘Tax Torpedo’

By Jim Terwilliger

If you are not acquainted with the term “tax torpedo,” you need to be if you are retired or are receiving (or are thinking of starting) Social Security retirement benefits.

Further, if you are enrolled in Medicare and are in a higher income bracket, your Medicare premiums can behave like a tax torpedo.

Finally, whether you are retired or not, the net investment income tax is an additional income tax torpedo for higher income taxpayers.

Quite simply, a tax torpedo is a factor that causes your marginal tax rate to be higher than the tax bracket that equates to your taxable income. In other words, while your taxable income might place you in a particular tax bracket, the next additional dollar of income might cost you more than that bracket would suggest. A lot more in some cases.

It is important to know if you are subject to this phenomenon. If so, prudent control of income sources can mitigate the impact.

Social Security

We often advise clients to defer taking Social Security retirement benefits until reaching age 70, particularly for the higher-earning spouse if married. If you decide not to wait, you may be receiving Social Security benefits for several years between retirement and age 72 when required minimum distributions (RMDs) start. It is during this timeframe the “torpedo” can rear its ugly head.

The federal taxation of Social Security benefits can cause your marginal tax rate to rise dramatically even if staying within a tax bracket. How so? While as little as none of your Social Security benefit might be taxable, up to 85% can be taxable depending on other income. We often advise retired clients to consider making taxable Roth conversions during potentially lower-income years prior to when RMDs start. But doing so can elevate the taxation of Social Security from zero to as much as 85%.

For example, if you are in the 10% federal tax bracket, your marginal tax rate is 15% if 50% of your Social Security is taxable and 18.5% if approaching 85% taxability. If you are in the 12% federal tax bracket, your marginal tax rate is 18% if 50% of your Social Security is taxable and 22.2% if approaching 85% taxability. And if you are in the 22% federal tax bracket, your marginal tax rate is 33% if 50% of your Social Security is taxable and 40.7% if approaching 85% taxability. Yikes! (Once the 85% cap is reached, the torpedo disappears.)

Deferring Social Security to age 70 yields a benefit that is 24% or 32% higher than your full retirement age (FRA) benefit for FRAs of 67 and 66, respectively. It also opens a window of time to make a series of partial Roth conversions at a marginal tax rate no higher than your tax bracket rate. And if you’re in the 12% tax bracket, it also allows a window in which long-term capital gains can be realized at a zero federal tax rate.

Income-Related Monthly Adjustment Amounts (IRMAA)

If you are not familiar with IRMAA, you may get a rude awakening when starting Medicare. IRMAA ties Medicare premiums to your adjusted gross income (AGI) plus any tax-exempt interest reported on your federal tax return two years earlier.

In the bottom tier, the 2022 Part B premium is $170.10 per month per person for 2020 AGIs up to $91,000 for a single tax filer or $182,000 for married filing jointly. In the top (sixth) tier, the 2022 Part B premium is $578.30 per month per person for 2020 AGIs greater than $500,000 for a single tax filer or $750,000 for married filing jointly. Additionally, a Part D surcharge ranging from zero to $77.90 per month per person is applied across the six tiers.

Depending on which tier you are in, Part B premiums plus the Part D adjustment for a married couple can total from $340.20 per month to $1,312.40 per month. Yikes, another torpedo!

Incremental additions to income can push premiums into a higher tier and generate a marginal out-of-pocket rate greater than the associated tax bracket.

Net Investment Income Tax (NIIT)

This torpedo impacts higher-income retirees and non-retirees alike. NIIT is the lesser of 3.8% of net investment income or 3.8% of AGI exceeding $200,000 for single tax filers and $250,000 for married filing jointly. Again, incremental additions to income, depending on the nature of the income, can yield a marginal tax rate great than the associated tax bracket.

Tax planning, particularly for retirees, is a must. It includes managing the timing and sources of your income to achieve an optimal outcome. Be sure to engage your tax professional and financial planner to help guide you through this maze.

James Terwilliger, CFP®, is senior vice president, senior planning adviser with CNB Wealth Management, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at