Retirees With Dividend Income Are Getting a Surprise Tax Bill on Their Social Security - Here's Why

Experienced investors know that dividend income offers some big tax advantages. However, for some retirees, there is also a potential tax trap hidden in this type of income.

Before you start investing, learn some important lessons about how dividend income can trigger an unexpected and unwanted Social Security tax bill.

What is dividend income?

You get dividend income when you own stock in a company, and the firm pays you a portion of its earnings.

Many investors count on dividends to provide them with a steady stream of cash flow. Even when markets falter, dividend payments typically continue.

Others who receive dividends invest them back into the company in the form of purchasing additional shares of stock.

How dividends are taxed

Dividends held in taxable accounts are taxed in one of two ways: ordinary or qualified.

Ordinary dividends are taxed at the investor's income tax rate. On the other hand, qualified dividends are taxed at federal rates of 0%, 15%, or 20%. Your income determines which rate you pay.

Why investors love dividends

Many investors love dividend income because it is usually taxed at relatively low rates. Ordinary dividends do not offer major tax advantages because they are taxed at ordinary income rates.

However, the rates on qualified dividends are substantially below the rates people pay on other types of income, such as earnings from a job. In fact, with shrewd tax planning, it is possible for some investors to avoid dividend taxation altogether.

Why dividend income can increase Social Security taxation

Unfortunately, earning too much dividend income may cause more of your Social Security benefit to be taxed.

Social Security benefits do not face taxation until what is known as your "combined income" exceeds a specific threshold. The formula for determining combined income adds all of the following types of income:

• Adjusted gross income (AGI)
• Tax-exempt interest income
• One-half of your annual Social Security benefits

Dividend income is included as part of your AGI.

How much of your Social Security might be subject to taxes?

Thus, if you have a very good year in the stock market and rake in a lot of dividend income, it could push your combined income higher. That could mean more of your Social Security benefit will be taxed.

Here is when taxation of Social Security benefits begins:

• For those filing as an individual: A combined income that exceeds $25,000
• For those filing a joint return: A combined income that exceeds $32,000

Another way dividend income raises retirement costs

Dividend income can also make Medicare premiums more expensive.

As mentioned earlier, dividend income is included in your AGI. A slightly different definition of income, modified adjusted gross income, or MAGI, is used to determine whether you are subject to IRMA. This also includes dividends.

If your MAGI rises above specific thresholds, you could be subject to what is known as an income-related monthly adjustment amount (IRMAA).

This is a fee that increases premiums for Medicare Part B and Medicare Part D.

Who is subject to an IRMAA?

The government looks back at tax returns from the previous two years to determine whether you are subject to an IRMAA.

The current IRMA thresholds are:

• For those filing as an individual: A MAGI that exceeds $109,000
• For those filing a joint return: A MAGI that exceeds $218,000

Ways to avoid Social Security taxes and IRMAA

Any income you take in from a Roth IRA or Roth 401(k) plan is not added to your AGI, and thus does not increase your combined income. Roth withdrawals are also not factored into IRMAA calculations.

The same is true when you withdraw money from a health savings account (HSA) as long as the money is used to pay for qualified medical expenses.

So, boosting contributions to both Roth and HSA accounts, or even doing Roth conversions, during your working years can pay off when you make withdrawals from those accounts during retirement.

Get additional help in planning your finances

Planning ahead is crucial if you hope to avoid Social Security taxes and IRMAA. If the process sounds intimidating, don't be afraid to look to professionals for help.

A financial advisor or tax professional can offer guidance in the years leading up to retirement. This allows you to craft a strategy now that will pay off when you finally enroll in Social Security and Medicare.

Bottom line

For many years, investors have looked to dividends for their regular payouts and low tax bills. But if you aren't careful, dividends could push you into a tax bracket that will shrink your Social Security benefit or inflate your Medicare premiums.

So, if you want to avoid having to cope with increasing bills during retirement, make plans now to keep your income lower during your golden years.