If you are like most Americans, health care costs will likely consume a large portion of your retirement budget—and you need to plan for that.
There are a number of drivers behind this mounting retirement health care cost challenge. In general, people are living longer, health care inflation continues to outpace the rate of general inflation and the average retirement age is 62 for most Americans—that's three years before you are eligible to enroll in Medicare.
At age 65, you must enroll in Medicare during your seven-month initial enrollment period that begins three months before the month you turn 65. If you're still working at that time and receiving health insurance coverage that is “Medicare-creditable” through your employer or your spouse's employer, you'll have the opportunity to enroll in Medicare when that coverage ceases through a Special Enrollment Period. For most individuals, enrollment in Medicare A and B happens automatically when they turn 65.
Medicare in Brief
Understanding Medicare can be overwhelming at times but below are a few basics to keep in mind:
- Part A covers hospital costs after you meet a deductible. Medicare A is mandatory.
- Part B covers physician care and other medical expenses. Medicare B is mandatory.
- Part D covers prescription drugs.
Medicare Part C—also known as Advantage plans—are all-in-one managed care plans, offered by private insurers, that provide the services covered under Part A and Part B of Medicare and may also cover other services that are not covered under Parts A and B, including Part D.
Supplemental policies—referred to as Medigap policies—are offered by private insurers to supplement expenses that Medicare Parts A and B do not typically cover. The most common policies are Parts F and G. Part F can no longer be newly purchased, but many people today are grandfathered in.
Costs for Medicare A and B
Enrollment in Medicare A and B—also referred to as “Original Medicare”—is mandatory.
If you have 40 or more quarters of Medicare-covered employment (at least 10 years that you paid Medicare tax through employment), Part A should require no premium. However, if you need care, there are deductibles and co-pays.
On the other hand, Part B requires a monthly premium, aside from having a deductible and co-pays too. In 2022 the standard premium is $170.10. This Medicare B premium typically inflates year over year. Most people pay the standard Part B premium. However, if your Modified Adjusted Gross Income (MAGI) as reported on your federal income tax return from two years ago is above a certain amount, you'll pay the standard premium plus an extra charge called the Income Related Monthly Adjusted Amount (IRMAA). For example, if your MAGI in 2020 was $750,000 or more (for those married and filing jointly), then you will pay the maximum Medicare B premium of $578.30 in 2022. In 2023, your MAGI in 2021 will be reviewed to determine your Medicare B premium for 2023.
Managing Your Income
Managing your MAGI in the years leading up to and throughout retirement, to the extent possible, is important to avoid or mitigate Medicare B premium increases.
Most of us have a baseline of annual income that establishes a MAGI that may be hard to avoid. This means that you will have a certain Medicare B premium as a baseline, whether it be the standard premium or a higher one due to IRMAA.
A portion of your income you cannot “manage” would likely include recurring income in retirement like Social Security or pensions, as well as investment income like taxable interest, dividends and mutual fund capital gains distributions. In a sense, it is “forced” upon you and would establish a baseline of annual income.
Your income from businesses or trusts may also be manageable up to a point. For example, while Required Minimum Distributions (RMDs) are mandatory, you may be able to avoid recognizing a portion of this income by giving RMD funds to charity by way of a Qualified Charitable Distribution (QCD). In addition to RMDs, you may be able to manage capital gains by having a solid plan in place before selling any investments. You are encouraged to speak with a tax and/or financial advisor to discuss and review your options before making any decisions.
On the flip side, voluntary withdrawals from your portfolio are under your control. If you are retired and need to take a portfolio withdrawal to cover your spending, you may have a choice on which account to tap into—depending on the composition of your portfolio. If all your savings are in pre-tax retirement funds, you could increase your MAGI dollar-for-dollar by a withdrawal from such an account. However, if you also have Roth and taxable funds, you have a choice and can be strategic in terms of managing your income in relation to Medicare. A withdrawal from a taxable account cannot spur an increase in MAGI at all, depending on the cost basis of the securities sold, as well as the eventual net capital gains at the end of the year. A qualified withdrawal from a Roth account is not taxable at all and has no impact on MAGI.
Similarly, if you are executing Roth conversions—which are taxable events—you can tailor the converted amount in relation to the IRMAA brackets and your MAGI, which will impact your Medicare B premium two years later. Then again, the long-term benefit of Roth conversions (reduction of funds that are subject to RMDs, tax-free funds in later years) may outweigh the temporary pain of increased Medicare premiums. Even more so, executing large Roth conversions now—especially prior to age 63—may later reduce RMDs to such a degree that it may be easier to avoid jumping into a higher IRMAA bracket.
Ultimately, you should consult with your tax advisor and financial advisor on this issue. Together, they can help you craft a strategy to manage your income in retirement, that also avoids unnecessary increases to your Medicare premium.
Decisions about when to stop working, when to take Social Security and how to generate cash flow in retirement all factor into how you prepare to meet health care expenses. To help fill a gap in saving for health care expenses, consider increasing contributions to your tax-advantaged accounts—especially any Health Savings Accounts you may have, which enable tax-free spending on health care in retirement.
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This is not intended to provide legal, tax or accounting advice. Any statement contained in this communication concerning U.S. tax matters is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties imposed on the relevant taxpayer. Clients should obtain their own independent tax advice based on their particular circumstances.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
This presentation is for general information purposes only. It does not take into account the particular investment objectives, restrictions, tax and financial situation or other needs of any specific client.
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