Is there such a thing as being "too good" at saving into your retirement account? Surprisingly, the answer may be yes - when it comes to health insurance costs in your golden years. When figuring out how much one needs to save for retirement, most people often focus on dollar amounts alone. They tend to think of their retirement savings in a silo. What most fail to consider are the comprehensive "planning" aspects of retirement, and the potential side-effects of decisions that have been made over a lifetime.
One side effect in particular can cause your future Medicare premiums to skyrocket! This is caused by a commonly overlooked "surcharge" on Medicare premiums for high income earners. Before diving in, I suggest your read our brief article on "Understanding Medicare Premiums".
Additional Content Alert! See our attached "A Summary of Medicare Mind Map" at the bottom of the page for a better overall understanding of Medicare.
Income-Related Monthly Adjustment Amount - IRMAA
In addition to the "base" premiums you'll pay for Medicare Parts B & D, there's a devil in the details called the income-related monthly adjustment amount or IRMAA surcharge. This surcharge applies to those who have higher incomes, and only apply to Medicare Part B & D premiums.
The amount of the surcharge depends on a few things:
1. How you file your taxes - married filing joint, single, head of household, etc.
2. Your household Modified-Adjusted Gross Income or MAGI*. Do not get this confused with your household gross income or taxable income, there is a difference and sometimes it is significant.
MAGI for purposes of the IRMAA surcharge is:
Your Adjusted Gross Income (AGI) on your tax return + any tax-exempt interest, interest from US savings bonds for higher education, and most foreign earned income not already included in AGI.
*Note that the MAGI calculation is different when being applied for certain other credits and deductions.
3. The Social Security Administration (SSA) uses your income tax information in #1 and #2 from 2 years ago to determine if you owe an IRMAA.
Example: If you are 66 in 2022 and on Medicare, your Part B and D premiums may have an IRMAA surcharge if your MAGI was over a certain limit on your 2020 tax return when you were age 64.
The Social Security Administration publishes the IRRMA surcharge tables every year. Refer to these tables to determine if you are subject to IRRMA, and how much your personal surcharge may be. For very high income households, the surcharge can be substantial.
Please note that a single dollar over any table limit causes you to have to pay that next table surcharge for an entire year - this is otherwise known as a "cliff" surcharge. As you may have inferred by now it is important to try and mitigate MAGI (leave yourself a nice cushion), and plan appropriately when possible.
The Issue: How Pre-Tax Retirement Accounts Can Have a Drastic Effect on Your Medicare Premiums
Since Medicare premiums are affected by income (MAGI), we should aim to control income in order to minimize increases in health insurance costs. Most would say that this is a good problem to have since having more income isn't a bad thing, so who cares if you pay more each month for health insurance? However the point is that you can actually have more income/positive cash flow without having to increase your MAGI! Why not be as efficient as possible?
Controlling income that hits your tax return is not easy, it requires careful planning and isn't something that can be procrastinated. For some, there comes a point when controlling income is virtually impossible and therefore there is no flexibility when it comes to health insurance cost control. In practice, we often see this phenomenon with individuals and families who are fortunate enough to have annuity-like pensions and pre-tax retirement accounts (i.e. IRA, 401(k), 403(b), 457(b), SEP IRA, etc.) - which is actually quite common. These two factors combined can potentially cause a planning gridlock:
1. Those who receive an annuity-like pension - such as those who worked for the Federal Government or local municipalities (OPM/FERS/PERS), military, public school teachers, railroad employees, and those with private company pensions, etc. - turn on a taxable income stream that typically lasts the rest of their life. In addition, these pensions often have cost-of-living adjustments (COLA) that increase payments over time to help combat the effects of inflation. For some, Social Security will also be available and kick in by age 70 at the latest. These are usually guaranteed income streams that do not fluctuate downward, which means they become a "base" for MAGI.
2. All types of organizations mentioned can and often do offer some sort of retirement plan or profit-sharing plan known technically as defined contribution plans. These are retirement plans that allow employees to save on their own for retirement (i.e. 401(k), 403(b), 457(b), SEP IRA, SIMPLE IRA, etc.), and some allow for the sharing of profits by the employer. These are typically offered in-addition to a defined benefit plan which is the technical term for an "annuity-like pension". After age 59 1/2 the account owner has full discretion of when and how much to distribute from these accounts without penalty (457 plans don't have a penalty anyways) - until age 72 when Required Minimum Distributions (RMD) begin.
Often times we have found that these defined benefit plans or "pensions" cover most if-not-all one's financial wants and needs during their later years. We have seen this to be especially true when married couples each have their own pension plans. The issue often arises for those with pensions who also decided to start saving early on their own in their employer-sponsored retirement accounts (defined contribution plans).
While this is generally a good practice, it actually can cause an issue when the retirement account is comprised of mostly pre-tax dollars, and has accumulated a relatively large balance by the time the funds are distributed.
NOTE: "Pre-tax" dollars are contributions to a retirement plan such as a 401(k) in which the amount you put in is deducted from your paycheck before federal and state tax withholding (income taxes). This means that you have not paid income taxes on those dollars yet, and they can continue to grow in the account tax-deferred until you take the funds out one day in the future - which then every dollar is taxable. Please also note that payroll taxes (FICA, FUTA, etc.) are still paid on your pre-tax contributions into your employer-sponsored retirement account.
As mentioned, at age 72 (post SECURE ACT, Dec 2019), Required Minimum Distributions (RMD) begin for any individual who owns an account such as a 401(k), IRA, 403(b), etc. (defined contribution plan). This is a minimum amount that must be taken out of these accounts each year going forward - even if you don't need it. In other words, you can't just let all of the money sit there and continue to grow tax-deferred for life - the IRS wants their tax dollars.
The RMD amount changes each year and is determined by the aggregate account balances of all these types of accounts you own as of Dec 31st of the year prior, and a factor based on your age that is taken from IRS provided tables.
The first year RMD is typically ~4% of the aggregate account balances. Remember that every dollar of these distributions is fully subject to income taxation. If you do not take an RMD, there is a 50% penalty to the IRS on the amount you should have taken - So take it!
Example: Sally who is retired and age 72, owns an IRA with an account balance of $400,000 and a 401(k) account at a previous employer with a balance of $600,000. Her RMD will be based on $1,000,000. Her entire ~$40,000 (4% of $1,000,000) distribution will be income on her tax return, just as if she were receiving a paycheck from her previous employment. If she had not taken the RMD, her penalty would be $20,000!.
Add this potentially large RMD to the pension income (both of which you must take) and you can see that income (MAGI) can start to jump significantly. If there is a spouse with similar circumstances, it becomes extremely likely you will have increased Medicare premiums - for good. In these situations it is essentially too late to plan for the permanent increase in costs.
This is why financial planning before you reach you retirement years is so important! If you start planning a little earlier, or don't have a guaranteed income source like a pension, there are some planning strategies you can implement to mitigate or prevent the increase in insurance costs.
Solutions and Strategies
The solution itself is relatively simple: minimize income that hits your tax return. However, doing so gets complicated since we all need income to live off of right? Here are some strategies to consider depending on your situation:
- Strategically decide when to draw from sources that you can control such as: IRAs, 401(k)s, 457(b) plans, or other pre-tax sources to mitigate MAGI.
- If planning early enough, consider contributing to a Roth IRA or Roth 401(k) if eligible. If not eligible, consider the back-door Roth IRA strategy.
- Assess your situation with a professional and see if Roth conversions make sense. This will reduce the amount in retirement accounts that are subject to RMDs at age 72; This could give you added flexibility in the long-run, especially if you are to receive a lifetime pension.
- Remember that the interest that your cash makes in your bank accounts/CDs, as well as dividends and interest payments from your investments, are included in income (and MAGI). Not only that, but you can't simply avoid recognizing the income by investing in tax-free municipal bonds. As previously noted, the interest from municipals must also be included in MAGI for purposes of determining IRMAA!
- If you must sell investments in a taxable brokerage account to meet income needs, try to use tax-loss harvesting techniques when it makes sense.
- Consider using asset-location strategies by putting your interest paying investments (bonds and dividend paying stocks) in your pre-tax retirement accounts, and your growth-oriented investments in your taxable brokerage accounts. This can help you to diversify appropriately while limiting the income that hits your tax return. Seek a professional for help on this.
- Consider tapping into your tax-free or after-tax resources for a portion of your income such as: Cash, Roth IRAs, or cash-value life insurance, etc..
- If you are self-employed, need Medicare coverage, and continue to work beyond age 65: Make sure you contribute to pre-tax retirement accounts such as a SEP IRA to reduce your current income. For most self-employed, there will be no guaranteed pension at retirement. Therefore it is less likely that income distributions from pre-tax accounts later on will impact IRMAA (overall lower income without a pension).
- Be careful selling rental properties for large capital gains in any given year. This can unknowingly cause you to jump into an IRMAA bracket and you'll get a surprise Medicare premium bill in 2 years.
- Take distributions from your pre-tax retirement accounts or taxable brokerage accounts in years when you know your income will be lower than others - such as the year you stop working or before a lifetime pension kicks in (low to no income). This can help you stay in the lower tax brackets because you will control how much you take from these accounts. This can also put you in the lower 0% capital gains bracket. For 2020, you can make up to $80,000 in income (married filing joint) and remain in the 0% capital gains bracket!
- The taxable portion of Social Security is included in MAGI, so plan ahead on when to take Social Security (if eligible). Note that IRMAA alone should not be a determinant of when to claim Social Security.
The Bottom Line
When working with a professional on a comprehensive financial plan, these side-effects can be identified, mitigated, and possibly avoided. Don't make expensive mistakes during your working years by procrastinating planning for the future. Please remember that IRMAA surcharges alone should not be a determinant of when to make certain financial decisions. Financial decisions are entirely dependent on your personal situation and rarely black and white.
Cameron Valadez is a CERTIFIED FINANCIAL PLANNER™ in Riverside, California
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Waddell & Reed does not provide tax or legal advice. This information has been obtained from sources believed to be reliable but Waddell & Reed does not guarantee the accuracy or completeness of the information. The information is for educational purposes and it is not financial advice or a specific recommendation of any kind. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. (08/20)