Getting your Trinity Audio player ready... |
Retirement planning involves navigating numerous financial challenges, but perhaps none are as stealthy and potentially damaging as the tax traps that await the unprepared.
When retirement account statements arrive showing seemingly substantial balances, many retirees feel a sense of security without realizing that a significant portion of those funds may be destined for tax authorities rather than their own enjoyment.
To help illustrate this, I think it best to use a case study.
The Andersons’ situation—Robert (67) and Susan (65) with $1.5 million in combined pre-tax retirement accounts—represents a scenario for many American couples who have focused on diligent savings in their working years.
Like many retirees, they may not have fully accounted for how taxes will impact their retirement income and lifestyle.
Their combined pension and Social Security benefits create a solid foundation, but the tax implications associated with their retirement accounts could significantly reduce their spendable income.
The Couple
Robert and Susan Anderson
- Ages: Robert (67) and Susan (65)
- Combined pre-tax retirement accounts: $1.5 million
- Robert has a pension that will pay $3,000/month
- Both are eligible for Social Security benefits
- Robert’s estimated monthly Social Security: $3,500
- Susan’s estimated monthly Social Security: $2,200
- Current tax bracket: 22% (joint filers)
- State of residence: Pennsylvania
- Retirement timeline: Robert is retiring this year, Susan plans to work 2 more years
Tax Trap 1: “Uncle Sam’s Significant Claim”
The Andersons need to understand that within their $1.5 million in pre-tax accounts, there is a significant future tax liability. For traditional 401(k) plans and IRAs, they received tax breaks when making contributions, but now they will pay taxes on withdrawals in retirement.
When they look at their IRA statements and see that large balance, Uncle Sam is also excited because within that balance is a debt he is waiting to collect. Distributions from their IRA or other taxable accounts will be taxed as ordinary income, subject to both federal and state income taxes.
Based on the 2025 tax brackets, a married couple filing jointly with taxable income between $94,300 and $201,050 falls in the 22% bracket.
Given the Andersons’ combined pension and Social Security income, a substantial portion of their IRA withdrawals could be taxed at this rate or even push them into the 24% bracket for income between $201,050 and $394,600.
While the Anderson’s may want to enjoy this balance in retirement, we must remember they never paid income tax on this to begin with. Therefore, distributions count as ordinary income.
Tax Trap 2: “The RMD Dilemma”
Required Minimum Distributions (RMDs) start at age 73 or 75 per the SECURE Act 2.0.
The Andersons will be required to take these distributions even if they don’t need the funds. Failing to take an RMD can result in a penalty of 25% (reduced from 50% previously) on the funds that should have been withdrawn, with the possibility of further reduction to 10% if the error is corrected in a timely manner.
RMDs increase with age:
- At age 73: Approximately 3.65% of the account must be withdrawn
- At age 80: This increases to approximately 4.95%
- At age 85: Increases to approximately 6.76%
- At age 90: Increases to approximately 8.77%
These increasing mandatory withdrawals can push the Andersons into higher tax brackets in later years when they may have less flexibility to implement tax strategies.
Tax Trap 3: “The Social Security Tax Trap”
Each dollar withdrawn from the Andersons’ IRA can potentially increase the amount of their Social Security benefits that are taxable. This occurs through a calculation of what’s called “provisional income,” which includes adjusted gross income, tax-exempt interest, and half of Social Security benefits.
For 2025, the thresholds remain unchanged:
- Up to 50% of Social Security benefits are taxable when provisional income exceeds $32,000 (married filing jointly)
- Up to 85% of Social Security benefits are taxable when provisional income exceeds $44,000 (married filing jointly)
With their combined Social Security benefits of approximately $68,400 annually and pension of $36,000, they’re in position that there may not be much to undo this, unless new legislation could offer a break. But it’s likely that the more income the Anderson’s have, the less likely the 85% threshold will change for them.
Tax Trap 4: “The Medicare Premium Surcharge”
Taking distributions from tax-deferred accounts can potentially increase Medicare Part B and Part D premiums through Income Related Monthly Adjustment Amounts (IRMAA). This creates an effective “tax” that many retirees fail to anticipate.
We recently wrote about how this works, so for more information, click here.
For 2025, IRMAA applies to individuals with modified adjusted gross income (MAGI) above $106,000 or married couples with MAGI above $212,000. Based on 2023 tax returns used for 2025 Medicare premiums:
- Standard 2025 Medicare Part B premium: $185.00/month
- With higher income: Premiums can increase to as much as $560.50/month per person
The surcharges are based on modified adjusted gross income from two years prior. The Andersons could pay thousands of dollars in additional Medicare premiums if their taxable income is too high, with potential Medicare surcharges for a married couple reaching over $9,000 annually at the highest income levels.
Tax Trap 5: “The Widow’s Penalty”
When one spouse passes away:
- The surviving spouse will be forced to file as Single rather than Married Filing Jointly
- Tax brackets for single filers far less favorable for married filing jointly brackets
This “widow’s penalty” could result in the surviving spouse paying substantially higher taxes on the same income.
For example, in 2025, the 22% bracket for single filers ends at $100,525, while for married filing jointly it ends at $201,050. Income that was previously in the 22% bracket might now be taxed at 24% (and with a rising RMD, even higher).
RMDs continue based on the deceased spouse’s age at death, potentially creating higher taxable income for the surviving spouse. The combination of a lower standard deduction, compressed tax brackets, and continuing RMDs can dramatically increase the survivor’s tax burden.
Tax Trap 6: “The Inheritance Tax Trap”
If the Andersons pass away with substantial pre-tax assets:
- Non-spouse beneficiaries generally must empty inherited retirement accounts within 10 years
- Heirs could pay taxes at their own potentially higher tax rates during their working years
- If the children are higher income earners, this could result in heirs paying “up to 40 cents on the dollar” in taxes (when federal and state taxes are accounted for)
Beginning in 2025, non-spousal IRA beneficiaries must take annual withdrawals if the original owner reached RMD age.
The SECURE Act of 2019 eliminated the “stretch IRA” strategy, potentially increasing the tax burden for many beneficiaries.
Conclusion
The retirement tax traps outlined above can significantly impact your retirement savings and income. Without proper planning, a substantial portion of your hard-earned retirement assets could go to taxes rather than supporting your lifestyle or legacy goals.
For the Andersons and others in similar situations, strategic tax planning is essential. This may include Roth conversions during lower-income years, careful coordination of when to begin taking Social Security benefits, thoughtful planning around required minimum distributions, and consideration of state tax implications.
Utilizing a team like Hyperion Financial can help you strategically plan for whatever is ahead.
Remember, it’s not what you earn, but what you keep that matters. Tax-efficient retirement planning can make a significant difference in your financial security and quality of life throughout your retirement years.