Investment Implications of the Rising and Falling Pattern of Marginal Tax Rates for Retirees

Abstract

This article begins by explaining how income-based increases in Medicare premiums produce dramatic increases in marginal tax rates for retirees with relatively high levels of income. It then explains how the taxation of Social Security benefits causes most lower- and middle-income households to have marginal tax rates for a wide range of income after Social Security benefits begin that are either 150% or 185% of their tax bracket. By combining these two factors, the authors show that most retirees will have marginal tax rates in retirement that rise and fall frequently and sharply as their income increases. This article then explains how this rising and falling pattern of marginal tax rates should affect retired households’ withdrawal strategies from their financial portfolio, where withdrawal strategy is defined broadly to include Roth conversions.

TOPICS: Wealth management, retirement, social security

Key Findings

• • Due to income-based increases in Medicare premiums and the taxation of Social Security benefits, most retirees face marginal tax rates that rise and fall sharply as their income rises.

• • The marginal tax rates for retired households receiving Social Security benefits fall sharply when their income places them beyond the income level where 85% of Social Security benefits is taxable.

• • We encourage these single and married households to make Roth conversions to take advantage of the relatively low marginal tax rates that exist beyond this income level. However, the amount of funds that can be converted at these relatively low tax rates depends upon whether the household has begun Social Security benefits and whether it will be on Medicare 2 years hence.