Ask Liz Weston

Get smart with your money

Taxes

Q&A: Is the ‘tax torpedo’ coming for you? Here’s what you need to know

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Dear Liz: I am pondering the best time to begin drawing Social Security. I have no debt, am 61, retired and fortunate enough to have retirement funds that are projected to last until I’m 95 without Social Security. That said, when I begin drawing Social Security, I understand I am likely to get taxed at the full 85% rate based upon the monthly income I receive. Does it make sense to hold off on applying until 67 or later knowing that I’ll be taxed more on the higher income, or should I draw sooner, understanding the tax liability would be less? Or, when I begin receiving Social Security, would I cut back on the amount of retirement funds I receive monthly?

Answer: The way Social Security benefits are taxed is somewhat convoluted and easy to misunderstand. Just to be clear: You would never lose 85% of your Social Security benefit to taxes. But if you have income outside of Social Security, up to 85% of your benefit can be taxable at your regular income tax rates.

The taxes are based on what’s known as your “combined income,” which is your adjusted gross income plus any nontaxable interest plus half of your Social Security benefits. If you’re single and your combined income is between $25,000 and $34,000, up to 50% of your benefits may be taxable. If your combined income exceeds $34,000, you may owe tax on up to 85% of your benefits.

If you’re married filing jointly, combined income between $32,000 and $44,000 could trigger taxes on up to 50% of your benefit. If your combined income is more than $44,000, up to 85% of your benefit may be taxable.

Because of this unusual structure, people can face what’s known as a tax torpedo, which is a sharp rise and then fall in their marginal tax rates. If your income is high enough, you won’t be able to avoid the tax torpedo.

However, many middle-income people can mitigate its effects by delaying Social Security and drawing down their retirement funds instead. You can get some understanding of how this works by searching on the phrase “tax torpedo.”

For a more in-depth analysis, search for the research paper by William Reichenstein and William Meyer titled “Understanding the Tax Torpedo and Its Implications for Various Retirees.”

Consider discussing your situation with a fee-only financial planner who can model different scenarios and give you personalized advice.

Q&A: Inherited IRA taxes

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Dear Liz: I have about $16,000 in a Roth IRA that I plan to leave to my daughter. When she collects this on my death, does she pay tax on the withdrawals?

Answer: No. She would have to pay taxes on withdrawals if the money were in a regular inherited IRA, but not if the money is in a Roth. She will be required to withdraw the money within 10 years, though. Congress eliminated the so-called “stretch IRA” for most inheritors, so non-spouse beneficiaries can no longer stretch withdrawals over their own lifetimes.

Q&A: Consider taxes before retirement

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Dear Liz: I began converting two 401(k)s from previous employers to Roth IRAs. To lessen the huge tax hit, I decided to do the conversions over the course of seven years. Even with that, the tax hit is higher than I realized and too painful. Now that partial conversions have begun annually, am I required to complete the total conversion to 100%? Or can I stop midway and leave the remainder in the original accounts? Also, is there an age limit before which Roth conversions must be completed?

Answer: You don’t have to continue making conversions. (Before 2018, you could have even reversed conversions you already made, but that’s no longer possible.) There’s also no age limit for conversions, but the older you get, the less likely conversions are to make financial sense.

Conversions are a good bet if you expect to be in the same or a higher tax bracket in retirement. If you’re young and in a low tax bracket now, you can reasonably expect that to be the case.

As you approach retirement, though, the opposite may be true. Many people find their tax bracket drops once they retire. Why pay a big tax bill now if you can access the money at a lower tax rate later?

Then again, if you’re a good saver, you may discover you’ve accumulated so much that your tax bill will soar once you’re required to start taking minimum distributions at age 72. If that’s the case, then converting some of your retirement money might save you on taxes overall.

But you’ll want to discuss this with a tax pro or financial planner who can model how the conversions are likely to affect your overall finances, including any Medicare premiums, since those can increase with income.

Q&A: IRS changes on required withdrawals

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Dear Liz: When informing me of my required minimum distribution for 2022, my brokerage has apparently used a distribution period that differs from the one used in past years. This results in a distribution amount that’s noticeably smaller. I recall there was some talk of revising the IRS tables, but has this been done?

Answer: Yes. The IRS has updated the life expectancy tables used to calculate how much people must withdraw from their retirement accounts to reflect longer lifespans. That’s good news for people who withdraw only the minimums each year, since their required distributions will be smaller and the rest of their balances can continue to grow tax deferred.

Q&A: How a ‘like-kind’ 1031 exchange can help you defer real estate capital gains taxes

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Dear Liz: My husband and I are selling a commercial property for $600,000 and we have capital gains questions. Our Realtor said that we have 90 days to buy another property but suggested we don’t make a purchase due to the state of the economy at this time. We are looking for any suggestions to lessen our capital gains. Do you have any suggestions that we could look into or articles to read?

Answer: Your Realtor is referring to what’s known as a “like-kind” or Section 1031 exchange. These exchanges allow people to defer capital gains taxes when they sell commercial, rental or investment real estate as long as the proceeds are used to purchase similar property.

Section 1031 exchanges happen all the time, in all sorts of economic conditions, so your Realtor’s attempt to dissuade you based on “the state of the economy” is a bit odd. Also, like-kind exchanges don’t have to be completed in 90 days. Owners have 45 days to identify potential replacement properties and a total of 180 days to complete the transaction. There are a number of other rules you must follow, so you’ll want to use companies known as exchange facilitators that specialize in handling these transactions.

Your first step, though, should be finding a qualified tax professional. You’ve just experienced what can happen when you turn to non-tax professionals for tax advice.

While your desire to educate yourself is laudable, and you certainly can find books about taxes at your local bookstore, there’s no substitute for consulting an experienced tax pro who can give you personalized advice.

Q&A: Newlyweds’ home sale taxes

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Dear Liz: You recently wrote about how home sales are taxed but I have a question. My son was single when he bought his condo. He is now married and planning on selling it. Does he qualify for the $250,000 exclusion or the $500,000 exclusion?

Answer: As you know, the exclusion allows home sellers to avoid capital gains taxes on a certain amount of profits as long as they owned and lived in the home at least two of the previous five years. With married couples, only one spouse needs to meet the ownership test but both must meet the “use” test. In other words, both your son and your son’s spouse must have lived in the home for at least two years before the sale for the couple to qualify for the $500,000 exclusion. The couple must file a joint return in the year they sell the condo, and neither spouse can have excluded gain from the sale of another home during the two-year period before selling this home.