Let’s face it, paying for your health care isn’t the first item on your list when considering retirement planning. Unfortunately, it really should be near the top of your retirement considerations. Whether you plan for it or not, the cost of healthcare is going to be one of the largest expenses you’ll have to deal with.
According to a 2021 RBC Wealth report, 80 percent of pre-retirees have concerns about retirement healthcare costs, and more than half have done some planning.
While Medicare parts A and B will play the central part in health coverage for almost all Americans, there are nuances about these and the rest of the healthcare costs many don’t know about or fully understand. In addition to Medicare parts A and B, you will need Part D to pay for your drugs and a Medicare supplement plan to cover the gaps that parts A and B don’t pay for. We’ll discuss how those with a higher taxable retirement income will increase their Medicare Part B and D premiums and what they may be able to do about it.
I won’t discuss the potential retirement plan wrecker, Long-Term Care (LTC) costs; it’s a topic that needs more detail than I can provide here. Having said that, it does need to be mentioned and considered in any retirement planning process. According to Christine Benz of Morningstar, as of 2017, 52.3 percent of people over age 65 will need some form of LTC in their lifetimes. As the population ages and lives longer, the need and cost will increase at an alarming rate. Medicare does not cover most LTC needs and what it does is extremely limited. For those that have assets to protect, long-term care insurance must be considered. It’s expensive, but LTC expenditures are even more so.
You will have a myriad of expenses including
- Medicare Premiums for Parts B and D
- Out-of-pocket costs for copays
- Deductibles
- Premiums for your Medicare supplement
- Long-term care insurance and/or
- Costs associated with long-term care itself.
Here, we explore the reality of these costs and the need to plan for them, (as opposed to helping you choose the best options for your needs — that information is for another article).
When you add up the premiums, copays, deductibles, and out-of-pocket expenses, the same RBC report places the average annual spending on healthcare for a couple age 65 at $12,000. This rises to $21,000 at age 75 and $38,000 per couple who are 85 and over.
These numbers will increase due to inflation, which for healthcare costs have steadily increased at double the rate of inflation. A perfect example of this is the 2022 Medicare part B premium increase of 14.5 percent. The question is not if you can afford your healthcare costs when you retire — it’s Can you afford them for your entire retirement?
Pro Tip: Include all your healthcare costs in your financial plan and make sure to account for inflation.
First: Who Is IRMAA?
This is the tax that many people have never heard about. IRMAA or Income Related Monthly Adjustment Amount increases the Medicare Part B premium for higher-income earners (and yes, you are considered an earner even in retirement) based on which bracket they are in. Here’s a chart from medicare.gov that deserves your review.
You can see that for those in the highest brackets, the IRMAA tax increases the Part B premium by almost 3.5 times the base cost. If you’re married, double that. The worst part is that you also have another added tax on Medicare Part D premiums no matter which plan you choose.
The income brackets are the same as the Part B tax and add up to $935 per year for the highest income earners. Most retirees won’t hit the top bracket, but many will be in the first few. This adds thousands of dollars in increased premiums each year. With inflation, IRMAA can cost hundreds of thousands over your retirement.
Fortunately, there are things you can do to tame this beast. Control your income, control your taxes, and you can avoid part or all of this seemingly hidden tax. Here are some strategies to leverage…
1. Health Savings Account
The Most Tax Effective Way To Plan For Retirement Healthcare Costs
Planning should start early in your career. The most effective method for accumulating assets to pay for later healthcare costs is an HSA or Health Savings Account. These are offered in conjunction with a HDHP or high deductible health insurance plan, allowing you to put pre-tax dollars into an account that grows tax-deferred and can be used tax-free for healthcare costs later.
The secret here is to accumulate this money and pay for your current health-related expenses out of pocket. Most people in high deductible plans spend from their HSA year after year and never build any significant balance. The power here is the tax deferral and tax-free withdrawals if you use the HSA for healthcare expenses. No other account available can be funded pre-tax and allows you to use the distributions TAX-FREE!
By allowing the account to increase over years or decades while you’re working, the power of tax-deferred compounding will help it grow. You can also invest in these accounts, which presents an opportunity for even greater growth, albeit with market risks, so invest these accounts wisely.
There are significant taxes and penalties if the funds are withdrawn and used for something other than healthcare expenses. After age 65, the penalty is waived but the taxes will still need to be paid. In 2022, those with a qualifying HDHP can contribute $7,300 for a family and $3,650 for those with single coverage. After age 55, you can contribute an additional $1,000 per year. Since most employers are now offering HDHP coverage to cut their benefit costs, if you’re working, you likely already have this option available to you.
Pro Tip: Contribute as much as you can to the HSA. After you have accumulated enough to cover your deductible in case of an emergency, invest the rest as aggressively as you feel comfortable, and don’t touch it until after you retire. Then use it for healthcare expenses, tax-free! The non-taxed distribution will reduce your Modified Adjusted Gross Income (MAGI) compared to taking the same amount of your pre-tax retirement accounts — and possibly reduce your IRMAA impact.
2. Use A QCD
Reduce Your MAGI And Avoid Meeting IRMAA
It’s not alphabet soup: It’s one of my favorite retirement income planning tools that not only helps reduce your taxable income but is philanthropic as well. Most people make charitable gifts to their church, synagogue, or favorite charity, and because they no longer itemize, can’t deduct the donation. But by using a lesser-known tax provision, you can regain the ability to give money tax-free. Even better, the money isn’t ever included in your income, so it helps lower the amount that counts toward IRMAA.
A Qualified Charitable Distribution (QCD) is when you make a direct donation to a charitable or religious organization in lieu of a Required Minimum Distribution (RMD). Any 501c3 charity is eligible to receive these funds. Since the money is sent directly to the charity, it isn’t included in your income for the year of the gift. Even if you can itemize and deduct the donation, this technique will reduce your overall income and again possibly help avoid IRMAA.
As always, there are rules to follow. Since the QCD regulations were created by the Pension Protection Act of 2006 before the RMD age was raised to age 72, you can make a QCD gift at age 70.5 even though you aren’t yet subject to RMD. There is also a $100,000 per person annual limit on these types of gifts, which most of us won’t have to worry about!
Pro Tip: If you’re already making charitable donations, use the right kind of money to make the gift help you and the charity.
3. To Roth Or Not To Roth?
“Never paying taxes on money again is high on my list of very good things…”
First, if you’re eligible to open an account and make Roth IRA contributions, do it! A Roth IRA is funded with after-tax dollars but grows tax-deferred and can be withdrawn tax-free if you follow the rules. This year, eligible individuals can contribute up to 100 percent of their EARNED income or $6,000, whichever is less.
If you’re over 50 you can contribute an additional $1,000 to the account. There are income limits that phase out your ability to add to a Roth, but if you’re under the limits, do whatever you can to fully fund one every year. Never paying taxes on money again is high on my list of very good things. Since you can withdraw the money later in life and no taxes are due, there is no IRMAA impact in the years you make these withdrawals.
Traditional Or Roth?
This next tip — leveraging Roth 401k, 403b, or 457 accounts — is a double edge sword. Contributing to your workplace retirement account is a fantastic way to build wealth and invest for retirement over time. Most companies offer a Traditional and a Roth option in these plans. The difference is when you pay the taxes. In a Traditional plan, the contributions are made pre-tax and lower your taxable income in the year you earn the money. The taxes are paid on the withdrawal unless you do a QCD. Roth contributions are made with after-tax dollars and again if the rules are followed are never taxed again. Both accounts grow tax-deferred in whatever investment options you choose.
The challenge is to figure out which of these will give you the biggest tax benefit. Since we’re talking about healthcare costs and avoiding IRMAA, the Roth would be the way to go. The downside of this might be paying higher taxes now to avoid a lower tax rate in the future. That might not make the most sense if you’re in one of the top tax brackets.
I hope you are starting to see the pattern: Avoiding taxable income in retirement can save you tens or even hundreds of thousands of dollars over the course of your life by reducing or even completely avoiding the IRMAA tax. Planning how you make contributions while you’re working can pay big benefits when you retire.
Pro Tip: We haven’t gone into the details of the differences in Medicare drug and supplement plans or which is better for you. There are many places to find information on that. Start at www.medicare.gov to begin exploring your options there. Your cost will depend on what Medicare supplement and drug coverage you choose.
The information included in this article is not intended to be specific tax advice, and you should consult with your tax advisor on the tax impact of any contribution or distribution decisions you may make to any of the planning options I’ve discussed.