Will Taxes Eat Up Your Extra REtirement INcome?

This is a common question I get from our clients who are in partial retirement and continue to work for different financial and personal reasons. Purely mathematically speaking, you are always better off working because the government, luckily, will not take all of your income.

But the actual tax impact or the limited ability to implement other important planning strategies can surprise you as our clients learned in this case. I’m keeping everything in this case study identical to the actual circumstances. I will just change the names to preserve this couple’s confidentiality.

A bit of background before we get started.

• The wife, Roberta, fully retired a few years ago and has no plans to rejoin the workforce.
• The husband, John, owns a small professional practice and continues to work, earning roughly $65,000/year in business income.
• Both spouses have reached their 73rd birthday which means they are required to take sizable Required Minimum Distributions (RMDs) from their retirement accounts.

In one of our regular planning meetings, Roberta inquired if it makes sense for John to continue working given the tax impacts on his earned income. To address this question, we had to schedule a separate meeting and run multiple tax projections to analyze the outcome of different decisions.

Here are the results.

In their specific situation, the government takes a whopping 42% of John’s income (!). The taxes will be paid at 24% federal and 9% Maryland tax rates. Plus, as a self-employed business owner, John pays 15.3% in FICA taxes which include Medicare and Social Security taxes. To reiterate the point, once adjusted for various deductions, John pays 42 cents on each dollar of his business income.

But it doesn’t stop there. Increasing your income may result in higher Medicare premiums for both spouses.

In Roberta and John’s case, going into the next bracket for Medicare premiums would result in an increase in premium from $481 to $591 per person. In total, this would be an additional “tax” of $2,604/year for both of them in additional Medicare premiums.

Are there any other impacts?

Absolutely. As part of the planning process, we discussed the idea of multi-year Roth conversions. This strategy can be incredibly beneficial in the long run to clients with larger retirement accounts. Roth conversions offer tax-free growth and can often lead to more tax-efficient asset transfer to the next generation. (I will explain how it works in a separate newsletter.)

The problem with Roth conversions is the tax you pay is directly related to your income. So if your income is higher, you are able to convert a lower amount and stay in the same (i.e. lower) tax bracket.

For Roberta and John, given their sizable RMDs, we estimated hey can convert no more than $30,000 and stay in the same federal tax bracket (24%). The conversion amount in the same tax bracket would triple to $90,000 if John decides to stop working.

So what has John decided to do?

At least for now, John has decided to continue working as he feels passionate and actually enjoys his work. I’m perfectly fine with this decision because our clients have a clear understanding of the tax and other costs of one of them staying employed.

But if you are in partial retirement, do you understand the financial and other costs of continuing to work?