Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / The Tax Torpedo That Hits Early Retirees at 65
Transcript
- Lucas: Let me paint a picture for you. A couple named Jen and Mark — both 64 years old, retired at 52 with a $1.6 million traditional IRA and a paid-off house in suburban Atlanta. They've been living on roughly $55,000 a year, mostly from their IRA withdrawals. They file jointly, take the standard deduction, and have paid zero federal income tax for the past decade. Luna: Zero? That sounds like the dream. How are they pulling that off? Lucas: The standard deduction for married couples filing jointly in 2026 is $32,300. Then you add the 10 percent and 12 percent brackets. They keep their withdrawals under $97,000 taxable income, and with no other income, their effective tax rate is under 7 percent. But here's the rub: they're about to turn 65. Luna: And that's when Social Security kicks in. Plus Medicare. Plus — eventually — RMDs. Lucas: Exactly. At 65, Jen will start claiming Social Security — roughly $2,100 a month, so about $25,200 a year. Mark will wait until 67 for a slightly higher benefit. On the surface, that extra income seems manageable. But the way Social Security benefits are taxed creates a 'tax torpedo' — a steep marginal rate spike that can push their effective tax rate from single digits all the way up to 40 percent or higher. Luna: I've heard the term, but I've never seen the math. Walk me through it. Lucas: Sure. The formula for taxing Social Security is based on 'combined income' — your adjusted gross income plus nontaxable interest plus half of your Social Security benefit. If combined income is below $32,000 for a married couple, none of the benefit is taxed. Between $32,000 and $44,000, up to 50 percent is taxable. Above $44,000, up to 85 percent is taxable. Luna: And Jen and Mark are going to blow past that $44,000 threshold the moment they start taking Social Security, because they're also pulling from their IRA. Lucas: Right. In year one, they'll have $25,200 from Social Security. Half of that is $12,600. Add their IRA withdrawal of $55,000 — combined income of $67,600. That's well over $44,000, so 85 percent of their Social Security benefit becomes taxable. That adds about $21,420 of extra taxable income on top of their IRA withdrawal. Luna: So now their taxable income jumps from $55,000 to over $76,000 — and they're not even at RMD age yet. Lucas: Exactly. At 65, their marginal federal rate climbs from 12 percent into the 22 percent bracket. But because of how the Social Security taxation phase-in works, the real marginal rate on each additional dollar of IRA withdrawal can be as high as 40.7 percent — that's the torpedo. And it gets worse at 73 when RMDs kick in. Luna: At 73, the IRS requires them to start withdrawing from their IRA based on life expectancy tables. For a couple with $1.6 million, the first RMD is roughly $61,000. On top of Social Security. On top of any other income. Lucas: Jen and Mark's combined income at 73: $25,000 from Social Security, $61,000 from RMDs. That's $86,000 plus half of Social Security — $98,600 combined income. They're now solidly in the 22 percent bracket, and 85 percent of their Social Security is taxable. Their effective federal tax rate jumps from near zero to about 12 percent. But the marginal rate on that RMD dollar? Nearly 30 percent when you include the phase-in. Luna: And that's before we talk about Medicare income-related monthly adjustment amounts — IRMAA. Those surcharges kick in at $206,000 modified adjusted gross income for a couple in 2026. They're not there yet, but a big RMD year from a market surge could push them over. Lucas: And that's exactly the risk. A one-time spike from a large RMD could trigger two years of higher Medicare Part B and Part D premiums. The IRMAA surcharge for the highest tier is an extra $428 per month per person in 2026. That's over $10,000 a year in additional costs. Luna: So what should Jen and Mark do now, while they're still in their early 60s and before RMDs start? Lucas: They should be doing Roth conversions. They can convert a portion of their traditional IRA to a Roth IRA each year, paying tax at today's low rates — 12 or 22 percent — to avoid much higher rates later. If they convert $50,000 a year for the next eight years, they can drain their traditional IRA balance down to around $1.2 million, reducing future RMDs. Luna: But isn't that taxable income in the year of conversion? They'd have to pay tax on the converted amount. Lucas: Yes, but they pay at their current marginal rate. In their case, with no other income, they can convert up to $97,000 and stay in the 12 percent bracket. That's far better than paying 22 percent or more later. Plus, Roth accounts aren't subject to RMDs, so they can let that money grow tax-free for the rest of their lives. Luna: They need to be careful about the five-year rule for Roth conversions. If they need to access the converted funds before age 59 and a half, there's a 10 percent penalty on the earnings portion. But they're over 59 and a half, so that's not an issue. Lucas: Right. At 64, they're past the penalty window. The bigger concern is the pro-rata rule — each conversion includes a proportional share of pre-tax and after-tax money in all their IRAs combined. Since they have no after-tax basis, the full conversion amount is taxable. That's fine if they plan for it. Luna: One more wrinkle: the Net Investment Income Tax. If their modified adjusted gross income exceeds $250,000 for a married couple filing jointly, they pay an additional 3.8 percent on investment income. Roth conversions count as regular income, not investment income, so they don't directly trigger NIIT. But the extra income could push their investment income over the threshold. Lucas: Another reason to keep conversions below $250,000. For Jen and Mark, $50,000 a year keeps them well under that. But here's the key: they should start now. Waiting until 70 or 71 means they've lost years of low-tax conversion space. The window between retirement and RMDs is the sweet spot. Luna: And if they don't convert? What's the total tax hit over their lifetime? Lucas: Let's run a rough scenario. Assume Jen lives to 90, Mark to 88. With no conversions, their total federal income tax from age 65 onward is about $180,000 — mostly from RMDs and Social Security taxation. If they convert $50,000 a year from 64 to 72, they pay about $50,000 in conversion taxes over those nine years, but their future RMDs are smaller, and their total lifetime tax drops to around $100,000. That's an $80,000 savings. Luna: Eighty thousand dollars. For doing a few tax returns and paying a bit more each year. That's a huge return on planning. Lucas: It really is. And one more thing: the IRS Form 5329. If they ever make an excess contribution to a Roth IRA — say, they convert too much and exceed the annual limit — they need to file Form 5329 to pay a 6 percent excise tax each year until the excess is removed. It's a common mistake for people doing conversions without tracking their contribution limits. Luna: But Roth conversions don't have contribution limits, right? You can convert any amount. Lucas: Correct. The conversion itself isn't limited. But if they then contribute to a Roth IRA separately, the total of contributions and conversions is capped at the annual limit — $7,500 for those over 50 in 2026. The conversion counts as a contribution for purposes of the limit. So if they convert $50,000 and also contribute $7,500, they've exceeded the limit by $7,500. That's where Form 5329 comes in. Luna: Got it. So keep contributions and conversions separate. Another reason to work with a tax professional. Lucas: Absolutely. And look — this episode is possible because listeners like you support the show. If our conversations have helped you think about a decision differently, a small monthly contribution at buy me a coffee dot com slash fexingo keeps these episodes ad-free and independence-focused. It's a tiny thing that makes a big difference for us. Luna: Yeah, it's a listener-funded show — no sponsors, no pressure. Just people who find value in what we do and chip in to keep it going. We're grateful for every single one. Lucas: Back to Jen and Mark — one more layer. State taxes. Georgia has a flat income tax rate of 5.49 percent in 2026. That's in addition to federal. So their effective state rate on conversion income is about 5.5 percent. Still beats 22 percent federal later. Luna: But what if they move to a no income tax state like Florida or Texas before converting? Would that save them even more? Lucas: It could, but they'd have to be careful about state residency rules. And property taxes might offset the savings. For most people, the simpler play is to convert while living where they are, as long as the state rate isn't excessive. Luna: So the takeaway: if you're retired early with a big traditional IRA, start Roth conversions in your late 50s or early 60s, well before Social Security and RMDs begin. Pay the 12 percent tax now rather than 22 percent or more later. And watch out for the tax torpedo. Lucas: Exactly. Jen and Mark's story isn't hypothetical — it's the situation thousands of early retirees will face in the next decade. The tax code rewards those who plan ahead. A few years of proactive conversions can save a lifetime of unnecessary taxes. And that's real financial freedom.