Traditional retirement income planning, which emphasizes investing in tax-deferred vehicles such as 401(k) plans and individual retirement accounts, could be a ticking time bomb. And the reason could be surprising: higher Medicare premiums.
“All the taxes that have been deferred come home to roost at age 70,” said Elaine Floyd, director of retirement and life planning at Horsesmouth LLC, a training and professional-development firm for financial advisers.
That is when the combination of required minimum distributions from tax-qualified retirement plans, the taxable portion of Social Security benefits and, in some cases, a pension, can boost income to a level that triggers permanent increases in Medicare premiums.
If clients' modified adjusted gross income, which is defined as adjusted gross income (including the taxable portion of your Social Security benefits) plus tax-exempt interest, exceeds $85,000 for single people or $170,000 for those who are married, they will pay more for Medicare coverage.
There are five Medicare income brackets. Go even $1 over the threshold and clients get socked with a higher premium.
This year, that means the difference between a MAGI of $85,000 and $85,001 for a single person is a Medicare premium that costs an extra $42 per month. That is $504 more per person per year in Medi-care Part B premiums.
Higher-income beneficiaries also pay more for Medicare Part D prescription drug coverage. And that is before factoring in a supplemental Medigap insurance policy to cover most of Medicare's deductibles and co-payments.
In the third income tier, which applies to individuals with a MAGI of between $107,000 and $160,000, and married couples with a MAGI of between $170,000 and $214,000, the high-income surcharge this year will double the usual Part B monthly premium to $209.80, from $104.90 per person.
Wealthy individuals with income above $214,000 or married couples with joint income that tops $428,000 will pay $335.70 per person per month for Medicare Part B premiums alone. That is more than $8,000 in annual Medicare premiums for married couples before they pay any Part D and Medigap costs.
As a result of the Patient Protection and Affordable Care Act of 2010, which requires nearly universal health insurance, anyone who collects Social Security and is 65 or older must sign up for Medicare Part A, which is free. Those who continue to work and have health insurance through an employer with 20 or more employees can delay signing up for Medicare Part B and Part D until they stop working.
“It hammers home the point that Medicare is now a mandatory expense, and you will be penalized for having too much income,” said Dan McGrath, director of institutional marketing at Zenith Marketing Group Inc., a general agent for independent life insurance agents.
Zenith provides software to help advisers identify clients' potential out-of-pocket health care expenses and suggests solutions for holding down costs.
Cash value life insurance doesn't trigger higher Medicare premiums, as policy distributions and loans don't count in the Medicare MAGI formula.
Health savings accounts are another source of tax-free income in retirement when distributions are used to pay for medical expenses, including Medicare premiums.
“An HSA is one of the best vehicles that you could possibly have to offset your health care costs in retirement,” Mr. McGrath said.
Employees and self-employed individuals who have high-de-ductible health insurance policies can contribute money to a tax-deductible HSA. The money grows tax-deferred, and distributions are tax-free as long as they are used to pay for medical costs.
Unlike employer-provided flexible spending accounts, HSAs have no use-it-or-lose-it rule. Money can accumulate year-over-year and serve as a source of tax-free income to pay for health care costs during retirement.
But once individuals enroll in Medicare, they no longer are able to contribute to an HSA, even if they continue working. However, they can continue to use the tax-free distributions to pay for health care expenses.
Tax-free Roth IRA distributions also are exempt from the Medicare MAGI calculation.
Ms. Floyd suggests converting a portion of traditional IRA assets to Roth IRAs over several years.
“If you start in your 50s, you could complete your Roth conversions before Medicare premiums kick in,” she said.
One caveat: the Social Security Administration, which keeps track of income for Medicare premium calculations, looks back two years. So for those who become eligible for Medicare this year, the SSA will base their premium assessment on the 2011 federal income tax return that was filed last year.
Consequently, individuals probably shouldn't convert traditional IRA assets to a Roth in the year they turn 63 because boosting their AGI that year could affect the Medicare premium they pay when they become eligible for coverage at 65.
“Clients who have no tax-free income in retirement are doing themselves a disservice,” said Felix Malitsky, managing director of MetLife Financial Group.
Mary Beth Franklin is a contributing editor for InvestmentNews. firstname.lastname@example.org Twitter: @mbfretirepro