6 Stealth Taxes That Can Affect a Federal Employee’s Retirement

Each year, a greater number of retired individuals including federal retirees are subject to one or more “stealth” taxes.

A stealth tax is a tax levied in a way that is largely unnoticed or not recognized as a traditional tax. The phrase was used in the United Kingdom by the Conservative Party to attack the Labor Party government’s behavior and has been used in British politics since the 1990’s.

In the United States, a greater proportion of senior citizens have hit the income threshold and therefore must pay additional taxes on their benefits. This is called a stealth tax. This column presents six stealth taxes that can affect a federal retiree’s finances throughout retirement.

Of the six stealth taxes, all but one has been in existence for several years. Two of the stealth taxes are difficult to avoid due to their low-income threshold. While most of these stealth taxes may not kick in until retirement, planning for each stealth tax should begin several years before a federal employee retires and continues throughout his or her retirement.

Stealth Tax #1: 10-year Inherited IRA Payout Rule

This form of stealth tax is the newest stealth tax. The 10-year inherited IRA payout rule was created by the passage of the SECURE Act in December 2019. The law took effect for qualified retirement plan IRA owner deaths after December 31, 2019.

The law applies to beneficiaries of qualified retirement plans and IRA accounts. Surviving spouses and minor children who are not grandchildren, and other “eligible designated beneficiaries” (EDBs) are unaffected by the 10-year payout rule. EDBs continue to take distributions from qualified retirement plans and IRA accounts over their lifetime using the required minimum distribution (RMD) rules.

Children after reaching the age of majority and grandchildren are classified as “non-eligible designated beneficiaries” (non-EDBs). They no longer must take RMDs from their inherited retirement and IRA accounts. Instead, they must withdraw their entire inherited retirement and/or IRA accounts by the end of the 10th year after the death of the retirement participant and IRA owner.

There are two potential types of stealth taxes that have been created by the 10-year payout rule.

The first type of stealth tax is the form accelerated and potentially increased income tax liability compared to the tax liability created by the RMD rules.

The second type of stealth tax assessed by the IRS is an “excess accumulation” tax of 25 percent on the balance of funds remaining in any qualified retirement plan or IRA account at the end of the 10th year following the year of death of the qualified retirement plan participant or IRA owner.

Stealth Tax #2. Taxation of Social Security Retirement Benefits

This stealth tax is the oldest of the six stealth taxes. Taxation of Social Security retirement benefits began in 1984. The starting point for determining how much of an individual’s or married couple’s Social Security retirement benefits are subject to federal income tax is the determination of Social Security recipient’s “provisional income.”

“Provisional income” is the total of the Social Security recipient’s adjusted gross income including 50 percent gross Social Security benefits, plus tax-exempt interest, any exclusions from income such as interest from qualified US savings bonds and the foreign earned income or foreign housing exclusions.

Single individuals with provisional income of $25,000 to $34,000 are taxed up to 50 percent of their Social Security retirement benefits, and up to 85 percent of their benefits when their provisional income exceeds $34,000. Married filing joint returns with provisional income between $32,000 and $44,000 are taxed up to 50 percent of their Social Security retirement benefits, and up to 85 percent of their retirement benefits if their provisional income exceeds $44,000.

Unlike other income-sensitive thresholds, Social Security provisional income amounts have never been adjusted for inflation in 40 years. This means that many Social Security retirement benefit recipients are paying federal income tax on their Social Security retirement benefits. Some recipients are also paying state income tax on their Social Security retirement benefits.

Stealth Tax #3: Increased Medicare Part B Premium

Each year, a Medicare Part B enrollee’s monthly premium is determined using modified adjusted gross income (MAGI) from the enrollee’s federal income tax return two years prior to the current year.

In 2023, monthly Medicare Part B premiums begin at $164.90 per month. An Income Related Monthly Adjustment Amount (IRMAA) is added to the $164.90 monthly amount if a single individual’s MAGI was greater than $97,000 during 2021 and for a married couple filing jointly, if their MAGI during 2021 exceeded $194,000. Medicare Part B monthly premiums can be as much as $560.50 during 2023 for those enrollees in the top income threshold.

Medicare Part B monthly premiums can increase significantly in a particular year because of additional income (resulting in a higher MAGI) an enrollee received two years prior to the current year. This additional amount of income two prior years could have resulted from the net gain on a sale of a principal residence, second/vacation home or a rental property, or income generated as a result of a Roth IRA conversion.

Stealth Tax #4: Net Investment Income Tax (NIIT)

The net investment income tax (NIIT) is a surtax (equal to 3.8 percent) that has been around since 2013. The 3.8 percent surtax is imposed on an individual’s investment income such as interest, dividends, and capital gains, The NIIT surtax applies if an individual’s adjusted gross income (AGI) is above $200,000 for single filers or $250,000 for married couples filing jointly.

The NIIT’s reach is expanding. When Congress enacted the NIIT to help fund the Affordable Care Act, Congress chose not to adjust the $200,000/$250,000 thresholds for inflation in order to collect more tax over the years.

NIIT revenue has more than tripled since the NIIT took effect in 2013. According to IRS data, NIIT revenue has risen from $16 billion in 2013 to $60 billion in 2021. Over that eight-year period, the number of individuals subject to the NIIT has more than doubled from three million to seven million.

The 3.8 percent surtax applies to net capital gains on asset sales. This includes cryptocurrency, dividends, interest including CDs and bank accounts, and royalties. It also applies to net gains on the sale of a principal residence above the principal home sale exemption of $250,000 for single filers and $500,000 for joint filers. Wages, pensions, Social Security payments and taxable retirement payouts (such as from the traditional TSP and the Roth TSP) are not subject to the NIIT.

The 3.8 percent NIIT is in addition to the regular tax paid on investment income. Interest income is subject to ordinary tax rates which depend on one’s marginal tax bracket of 10, 12, 22, 24,32,35, or 37 percent. This means that an individual who is in a 24 percent marginal tax bracket and who is subject to the NIIT and has interest income, will pay a 27.8 percent tax on that interest income.

For qualified dividends and long-term capital gains which is subject to a preferential tax rate of 15 percent or 20 percent, an individual with qualified dividends and long-term capital gains and subject to the NIIT will pay a total tax of 18.8 percent or 23.8 percent respectively on the qualified dividend and long-term capital gains income.

Stealth Tax #5: Widow(er)’s Income Tax Penalty

The widow(er)’s income tax is probably the “stealthiest” of the stealth taxes in the sense most widows/widowers are not aware of it. It is also the most difficult stealth tax to plan for, and it can potentially increase a widow(er)’s federal and state income liability each year once it starts.

The federal income tax is unfortunately not kind to a surviving spouse, particularly in the year following the year of death of the other spouse. A widow or widower who has the same or even less income than the married couple had before the first spouse died will often find himself or herself in a higher federal and sometimes state income tax marginal tax bracket.

The main reason for this inequity is the transition from married filing joint tax rates to single tax rates and a standard deduction of 50 percent of the married filing joint amount ($25,900 during 2022) to $12,950 (2022), beginning in the year following the year of death of one’s spouse.

Stealth Tax #6: $10,000 Limitation on State and Local Taxes

Under Internal Revenue Code Section 164, state, local and foreign taxes may be deducted on IRS Form 1040 Schedule A as itemized deductions. However, for tax years beginning after December 31, 2017 and before January 1, 2026, a cap is placed on the state and local tax deductions available to individuals.

Individuals (whether they file as single, head of household, or married filing jointly) are limited to a maximum annual deduction of $10,000 ($5,000 in the case of a married individual filing a separate return). The $10,000 cap applies to single filers and to married filing tax filers) and applies to state and local income taxes or general sales taxes, real estate taxes and personal property taxes.

Also, individuals cannot deduct foreign real estate or property taxes. This change, combined with the doubling of the standard deduction and reduced mortgage interest deduction, has reduced the percentage of individuals itemizing their deductions on federal and state income tax returns. The overall result is that more individuals are taking the standard deduction on income tax returns. If they live in a state with a high state and local income tax, they are most likely paying more in overall taxes, especially on the state and local level.