Understanding Medicare
Medicare is kind of like Chipotle. I like Chipotle. It’s better than Taco Bell. But it’s not perfect–it’s not Goode Co Cantina or Lupe Tortilla. In other words, Medicare really is pretty good. Getting to age 65 is a big deal in retirement planning because the health care options before Medicare can look much worse–it can feel like Taco Bell except you’re paying Lupe Tortilla prices But there are things you can do to impact your potential medicare premiums.
In this article, I want to do three things:
Explain the basics of Medicare
Explain how taxes and income determine your premiums
Give you a strategy to potentially lower your premiums
The Basics. Medicare has a few basic components to it.
Part A-hospital insurance
Part B-more comprehensive medical insurance
Part D-prescription drug coverage
Part C-This can be an alternative option, a Medicare Advantage Plan. This is an all in one option combining the above components and potentially offering extra benefits-like vision, hearing, and dental.
Medigap Policy-Different Medicare Advantage Plans, Medigap helps supplement original Medicare. In fact, it’s illegal for anyone to sell you a Medigap plan if you already have a Medicare Advantage Plan. It helps pay for things like copayments and deductibles.
Medicare Penalties. Medicare penalizes you every year that you do not enroll. For example, your Part B premium goes up 10% for every 12 month period you could have had Part B. These penalties are permanent. So, it’s critical to stay on top of it and not cause lifelong Medicare premium penalties.
What Should You Choose When Enrolling? Let’s go back to the Chipotle example. If you eat the same thing at Chipotle too much, you’ll get sick of it. The good news is you can change your order enough to get a very different meal.
Barbacoa with pico and hot salsa is very different than chicken with corn salsa, guac, and sour cream. Which one is better? Well, that’s really up to you.
Medicare is the same way. Whether you pick a supplement offered by your previous employer, another Medicare Advantage Plan, or simply original Medicare (and maybe with a Medigap policy) is up to you. It’s a matter of figuring out your health care needs and matching it with the best solution for you.
This is similar to choosing a health insurance plan at work or through the ACA exchange. You can estimate what you think your health care needs will be. You then choose either a high deductible with lower premiums or a low deductible with higher premiums (among other options). If you pick higher premiums and hardly use it, you’ll wish you would have chosen lower premiums with a higher deductible.
Understanding Medicare Premiums-Income Tax Brackets
Your Medicare premium is influenced by your income. This is a big deal. This means you have influence and control over your future Medicare premiums. We will dive into how to strategize this in the next section. First, take a look at the Medicare income tax brackets below:
As the tables above show (Source: Medicare.gov), your Medicare premiums have a direct correlation to your taxable income. The takeaway here is that you can substantially lower Medicare premiums by navigating your income tax through retirement. That leads us to our last section.
Lowering Medicare Premiums Through Tax Planning
Retirement is a big topic because there are so many different facets to cover and consequences to avoid. I firmly believe a great financial planner has to help clients avoid paying the IRS too much. This sounds like a topic more built for their CPA (or whoever files their return). However, it has to start with the financial advisor. Why? In retirement, your assets and your portfolio largely determine your income. Even more fascinating, you (and your advisor) get to influence when and how you recognize this income!
It’s like being at a restaurant, and it has all of the food you’ll eat for the next thirty years. You can go to the restaurant periodically when it’s mealtime, or you can take all of the food home at once.
Except, it’s even worse! You have one asset bucket (pre-tax IRA/401k) that you’re forced to take starting at age 72. If we don’t plan ahead, you’ll end up paying a large amount of taxes throughout your life from that bucket. For Medicare, this is a big factor.
I’ve written extensively on Roth conversions. They can play a big role in your long-term Medicare premiums. But more importantly, they can lower your overall tax rate on your assets. As a reminder, Roth conversions are taking a chunk of your pre-tax IRA and sending it to a Roth IRA. For most retirees, this is a critical step to lower future taxes. And, as you can imagine, most retirees are very overweight in pre-tax retirement accounts as the picture below shows. However, if you convert too much to a Roth, you can voluntarily force yourself into higher Medicare premiums when it’s not worth it.
If you’re in or entering Medicare age and have assets over $2 Million, proper Medicare and tax planning can save you a great deal. Let’s look at three different scenarios with different asset levels: $2M, $5M, and $8M. In each scenario, we’ll assume 80% of the assets are in a pre-tax IRA-subject to income tax and required minimum distributions starting at age 72.
At 2M, it likely makes sense to do as much Roth conversions as you can up to the top of the 12% tax bracket (~$102,000 in income if you’re married filing jointly). It may even make sense to go above that mark into the 22% tax bracket. It likely does not make sense to go above $174,000, as this would trigger Medicare premium increases. Doing Roth conversions at these lower levels will help ensure your Medicare premiums stay below $174,000 decades from now.
At 5M, you’ll want to be even more aggressive with Roth conversions. From age 65-72, you’ll likely want voluntarily trigger Medicare premiums by engaging in higher Roth conversions. If you delay Social Security to avoid any unnecessary income, you could contribute around $300,000 per year and still stay within the 24% marginal income tax rate. While Medicare premiums will increase because of this, your future tax burden is too large to do otherwise. Another way to look at it: Not doing all the Roth conversions you can at 24% will end up (most likely) costing you far more than the extra Medicare premiums during this time. It’s worth it to pay $425/month from age 65-72 if it allows you to convert over $2 Million to your Roth during this period ($300,000 Roth conversions x 7 years = $2.1M).
NOTE: Remember, RMD’s (required minimum distributions) will force you to take taxable distributions from your IRA every year starting at age 72. While the amount starts around 4%, the RMD % increases each year. So, if you have a $4M IRA at age 64, you could be looking at a $6-8M IRA at age 72. 4% of $6M comes to $240,000 in annual income—on top of Social Security and any other income you have. At age 82, you could be looking at RMD’s of $350,000-$400,000 depending on investment performance.
ALSO NOTE: While the $240,000 annual RMD at age 72 may not sound alarms, your RMD gets larger every year as noted. In addition to this, if one spouse passes away several years before the second spouse, the surviving spouse will face substantially higher income taxes as a single tax payer. Finally, your children will be forced to liquidate the entire inherited IRA within 10 years. It’s important to remember your entire IRA balance will be taxed at some point. That’s why it likely makes sense to pay up to 24% to convert part of your IRA assets to a Roth IRA—however it plays out in the next couple of decades, part of your IRA will likely face taxes higher than 24%.
At 8M, I think you can guess my thoughts on the subject. You’re facing quite a large Medicare bill and tax bill. You’ll almost certainly want to fill up the 24% tax bracket with Roth conversions up to age 72. You’ll also want to be cognizant of your non-retirement assets and the tax consequences they are producing.
