Beware the Tax Torpedo! 

You are collecting Social Security, living off after tax savings, and have little other income to speak of.  You think “Hmmm, I am not really paying any income tax at this level, why not go and convert my IRA to a Roth?” You figure, heck, the tax bracket on income up to $82000 is only 12% - so that is all you will pay on the conversion, right.  You decide to convert $50,000 of your IRA to a Roth.

When you do your taxes including the conversion, however, you find out that instead of your tax bill increasing by $7500 (12% of the $50k conversion) they actually increased by almost $12,000.  BAM!  You are blindsided by a TAX TORPEDO!  Well, you were right that you would only pay 12% on the Roth conversion, but the extra income you created means that now up to 85% of your Social Security income that wasn’t taxed before suddenly is being taxed at that same 12% rate.  Your overall increase in tax was as high as 24%. 

A tax torpedo is when additional income suddenly thrusts you over an income threshold where some other tax is incurred, or where a valuable credit or deduction is lost. 

An example all too familiar to New Jersey seniors is the Retirement Income Exclusion which allows taxpayers over 62 to exempt retirement income (including IRA distributions) from New Jersey state income tax.  That exemption starts to phase out when total income (NJ doesn’t include Social Security in its calculation) exceeds $100,000, and completely goes away at $150,000 in (non Social Security) income.  This is a particularly powerful torpedo because $1 of extra income to someone who is making $99,999 in income a year may cost them a couple thousand dollars in additional state income tax!  

Other powerful torpedoes include the $1 in extra income that can push you up into the next bracket for Medicare rates. 

Or the extra income that pushes you into the 22% tax bracket where previously tax free dividends and capital gains are now taxed at 15%. 

Almost any tax credit or deduction that has a phase out or phase in can have the effect of a tax torpedo. 

Tax planning can be incredibly complicated.  Even us financial professionals have trouble keeping up with all the implications.  It may therefore be impossible to avoid every tax torpedo – but having a well designed and crafted financial plan may be able to help you avoid the worst of them.