Medicare and budgeting for future medical expenses are important elements of personal financial planning. Sometimes, controlling Medicare premium costs is overlooked and estimating future medical out-of-pocket expenses is understated. Accordingly, this article focuses on Medicare planning issues that CPA financial planners should consider when advising clients. These issues include an overview of Medicare taxes, the determination of premium surcharges, projected future health care costs, and strategies to mitigate the impact of the escalating Medicare charges paid by many higher-income clients.
Medicare has been enduringly popular since it began in 1966. It provides health insurance to Americans over age 65 and to many younger people with disabilities and certain illnesses. For most of the history of Medicare, everyone paid the same premiums. There was no "means testing." However, since 2007, as a result of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003, P.L. 108-173, people of certain income levels have been required to pay surcharges for Part B of Medicare (outpatient medical coverage). Under the 2010 Patient Protection and Affordable Care Act, P.L. 111-148, those same individuals may also pay more for prescription drug coverage under Part D. The Medicare Access and CHIP Reauthorization Act of 2015 (MACRA), P.L. 114-10, increased the cost of Medicare for higher-income beneficiaries starting in 2018. The aim of MACRA is to significantly increase premium revenues moving forward.
The median traditional Medicare health care costs (premiums, co-pays, and out-of-pocket expenses) for a person age 65 in 2019 are estimated to be $5,160 (Guide to Retirement, J.P. Morgan Asset Management, 2019, page 31, available at am.jpmorgan.com. The annual health care cost inflation rate is 6.5%. This implies that median health costs, which include Medicare premiums and surcharges, for a person age 85 in 2039, 20 years from now, can be estimated to be $18,180 from inflation alone, not taking into account the likely higher medical costs related to aging. The base Medicare premium for 2019 is $135.50 per month. Surcharges are imposed on beneficiaries with higher income: single taxpayers with modified adjusted gross income (MAGI) in excess of $85,000 and married couples with MAGI greater than $170,000. A single retired individual earning $110,000 in 2019 will pay additional premiums (surcharges) of $2,008 and have estimated annual current median health care costs of $7,168. A married couple with retirement income of $325,000 will pay additional premiums of $4,426, and their annual current median health care costs are estimated to be $9,586 (Guide to Retirement, page 31). Health care costs for retirees are substantial and increasing faster than the average conventional inflation rate; these costs definitely need to be considered when doing prudent financial planning. Increasing Medicare surcharges make it very important for affluent individuals to engage in proactive tax planning.
MEDICARE ALPHABET SOUP
There are two plan choices for Medicare: traditional Medicare or Medicare Advantage. Individuals (and their spouses) who have paid Medicare taxes for 40 quarters are eligible for Medicare at age 65. Disabled individuals have different eligibility rules; consult the Medicare.gov website for the details. Medicare has basically four parts:
Part A: Inpatient hospitalization, premium-free;
Part B: Doctors, tests, and outpatient hospital insurance;
Part C: Medicare Advantage, an alternative to Parts A and B and, often, Part D; and
Part D: Prescription drug insurance.
If clients don't sign up for Parts B and D at the right time (eligibility starts at age 65), they may be subject to significant permanent lifetime penalties, and late filing can leave them with no primary health insurance. Individuals are not required to sign up for Medicare Parts A, B, and D if they have other "creditable coverage" such as through an active group health insurance plan. Regardless of other coverage, however, recipients of Social Security benefits at age 65 or older must take Part A, for which they pay no premium.
Medicare taxes are assessed on earned income (wages and self-employment income). The Medicare tax on wages is paid by both employees and employers at a rate of 1.45% on 100% of wage income. There is no exclusion for income over a salary base as is done with Social Security taxes. Self-employed individuals pay both the employee and employer portions of the tax (2.9%) on their net self-employment income. An additional 0.9% Medicare surtax is levied on wages and/or self-employment income above $250,000 for married individuals filing a joint return, $125,000 for married individuals filing a separate return, and $200,000 in any other case.
Taxpayers may also be required to pay the net investment income tax, which is the equivalent of a Medicare tax on investment income that is subject to the tax. The Sec. 1411 net investment income tax was enacted by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, which gave it the heading "Unearned Income Medicare Contribution," although it is not designated as a specific revenue source by the trustees' reports of the Medicare trust funds in the same way as payroll taxes. The net investment income tax is imposed at a rate of 3.8% on the lesser of net investment income or the excess of MAGI over $200,000 for single individuals and $250,000 for joint filers. (MAGI for purposes of the net investment income tax is adjusted gross income (AGI) increased by foreign earned income properly excluded under Sec. 911(a)(1) over the amount of any deductions (taken into account in computing AGI) or exclusions with respect to the excluded income that are disallowed under Sec. 911(d)(6). For Medicare purposes, MAGI is AGI plus the following tax-exempt income: tax-exempt interest income; income from U.S. savings bonds used to pay higher education tuition and fees; foreign earned income; and income from sources in certain U.S. territories (see Sec. 1411(d) and 20 C.F.R. §418.1010(b)(6), respectively)). Again, the threshold is one-half for married taxpayers filing separately.
For example, if a single taxpayer had MAGI of $250,000 and $225,000 of net investment income, the individual would need to pay net investment income tax of $950 ($25,000 × 3.8%). Two single high-income individuals who decide to get married may see their net investment income tax liability increase as a result of being married and filing jointly, versus their combined tax if they remained single.
MEDICARE PREMIUMS AND SURCHARGES
There is no premium or surcharge for Part A. Each year, the Centers for Medicare & Medicaid Services (CMS) sets the following year's Part B premium. As noted previously, the 2019 base Part B premium is $135.50 per month per beneficiary. Most people pay that amount. A small number of people pay a premium that is lower than the base premium because they are protected by the "hold harmless" rule. The hold-harmless provision protects people from having their previous year's Social Security benefit level reduced by an increase in the Part B premium.
Part D coverage is provided via the individual private plan selected by the beneficiary, and base premiums depend upon the plan chosen. Wealthier taxpayers may also pay Medicare surcharges on Parts B and D in addition to the base premium for traditional Medicare or a Medicare Advantage plan. Higher-income individuals paying surcharges are not shielded by the hold-harmless provision. The table "Medicare Parts B and D Premiums for 2019" shows the amounts charged for Part B (base premium plus surcharges) and Part D (surcharge only) at the various income thresholds for individuals and joint filers based upon MAGI from two years prior. In other words, the premiums for 2019 are based upon the reported income tax data from 2017.
Medicare Parts B and D premiums for 2019
The surcharges are referred to by the Social Security Administration (SSA) as income-related monthly adjustment amounts (IRMAAs). The surcharge tiers are "cliff" thresholds — meaning even $1 of income past the threshold results in the entire (higher) surcharge being applied. Surcharges can be a big surprise to someone who experiences a one-time increase in income from, for example, the sale of a home, a withdrawal from a retirement account, or a sale of securities. Surcharges caused by a one-time increase in income will disappear when income levels return to normal.
The Part B premiums that beneficiaries pay are only 25% of the actual premium cost, the SSA advises, with the government covering the remaining 75%, referred to as cost sharing. Beneficiaries pay a larger percentage of the total Part B Medicare premium cost as their reported level of income increases. Beginning in 2018, the IRMAA surcharges apply even more quickly, as MACRA reduced the MAGI thresholds and increased cost-sharing percentages for two of the six threshold tiers. Higher-income beneficiaries pay monthly Part B premiums equal to 35%, 50%, 65%, 80%, or 85% of the total Medicare premium. They also pay increased surcharges for Part D. Retirees may be responsible for Part D surcharges even without their own Part D plan in certain situations. See the SSA's guide Medicare Premiums: Rules for Higher-Income Beneficiaries for more information on this topic. IRMAA surcharges are projected to affect only 5% of enrollees. However, those affected by the surcharges should plan accordingly.
An appeal process is available to help beneficiaries whose current incomes are substantially less than their MAGI amount from two years previously. Any of eight specific "life-changing events" might qualify beneficiaries for reconsideration of their IRMAA:
- Death of a spouse;
- Divorce or annulment;
- Work reduction — retirement or reduction of hours worked;
- Work stoppage;
- Loss of income from income-producing property due to a disaster or event beyond a person's control;
- Loss or reduction of certain kinds of pension income; or
- Employer settlement payment.
For example, if an individual retires and his or her income declines in subsequent years, this new, lower income level can be used to argue against an IRMAA charge that was based upon pre-retirement income. Beneficiaries may file Form SSA-44, Medicare Income-Related Monthly Adjustment Amount — Life-Changing Event, after they receive a notice that their Medicare premiums for Part B and prescription drug coverage include an IRMAA. The notices are sent out when beneficiaries first apply for Medicare and in November for people with existing coverage. It is important to review the notices and verify that the data is correct. Beneficiaries whose circumstances do not fit the specific criteria on Form SSA-44 have the option to file Form SSA-561-U2, Request for Reconsideration.
MEDICARE PREMIUMS AND SURCHARGES EXAMPLES
Below are three examples of how Medicare premiums and surcharges are computed. Understanding the calculations will help clients appreciate and understand the strategies to lessen the impact.
B is single. He usually reports MAGI of about $75,000 per year. He is enrolled in a Medicare Part D plan. In 2017, when his other income included in MAGI is $77,500, he is considering withdrawing an additional $32,500 from his traditional IRA to purchase a car for cash, for a total MAGI of $110,000. How much more will B need to pay in 2019 for Medicare premiums?
If he makes the withdrawal, B will need to pay total Medicare costs of $3,633.60 [($270.90 (Part B) + $31.90 (Part D)) × 12] in 2019, or $2,007.60 in excess of the base premium cost, if his MAGI is increased by the $32,500 (see the table "Effect on Premiums of an Additional IRA Withdrawal"). The excess premium will be incurred only for 2019, provided his MAGI in 2018 dropped back below $85,000. The excess premiums represent an increase in household expenses as a percentage of his 2017 income of 1.83% ($2,007.60 ÷ $110,000) or 2.59% ($2,007.60 ÷ $77,500) of his normal income level. In this case, B may want to try to keep his income below the $85,000 surcharge threshold by financing his purchase or leasing the car. He could withdraw enough from his IRA to service the debt and still stay below the threshold.
Example 2 concerns a couple who have not signed up for a Part D plan; however, they must still pay Part D surcharges, since a former employer has enrolled them and is paying the basic cost as a fringe benefit.
Effect on premiums of an additional IRA withdrawal
A married couple report MAGI in 2017 of $320,000. A former employer enrolled them in a Medicare Advantage plan with Part D coverage. How much should the couple expect to pay for Medicare premiums for 2019?
In this example, the couple need to pay total Medicare premiums of $9,686.40, which is $6,434 greater than their base premium [$9,686.40 − ($271.00 × 12)] (see the table "Premiums for a Married Couple"). Their MAGI is just within the fourth threshold. The additional Medicare cost represents 2.01% ($6,434.00 ÷ $320,000) of the annual income.
Example 3 illustrates the "cliff" effect of the Medicare premium costs.
Premiums for a married couple
Assume the same facts as in Example 2, except that the couple received $1 more income and their MAGI is $320,001. How much more will the couple need to pay in Medicare premiums?
In this example, the couple will pay total Medicare premiums of $12,103.20 (see the table "'Cliff Effect' for a Married Couple"). The additional $1 of income increases their Medicare costs by $2,416.80, which is a nearly 25% increase in Medicare costs ($2,416.80 ÷ $9,686.40). This highlights the need to monitor annual income levels and the importance of proactive tax planning. The additional Medicare costs represent 2.77% ([$12,103.20 — ($271.00 × 12)] ÷ $320,001) of the couple's annual income.
'Cliff effect' for a married couple
MEDICARE PLANNING STRATEGIES
Single individuals with MAGIs above $85,000 and married couples with MAGIs above $170,000 are subject to the IRMAA rules. Medicare surcharges can easily increase a household's expenses substantially. The cost-sharing aspect of the surcharges means that higher-income beneficiaries may experience increases for additional Medicare premium costs that exceed normal inflation expectations.
Roth IRA distributions and qualified health savings account (HSA) withdrawals are not included in gross income and therefore do not generate IRMAAs. People in pre-retirement years (but not within two years of Medicare coverage) may want to consider contributing to Roth retirement plans and HSAs. Individuals in this time frame may also want to consider Roth conversions. With a Roth conversion, individuals pay tax when they convert from a traditional IRA, but they can withdraw their money tax-free in retirement. Pre-retirement Roth conversions can be a way to reduce post-retirement income below the IRMAA thresholds.
Withdrawals from HSAs, as long as they are used for health care expenses (including Medicare premiums), are "triple-tax-free" — taxpayers receive a deduction when contributions are made, contributions grow on a tax-sheltered basis, and contributions can be withdrawn tax-free. The pre-retirement years are a good time to rebalance and reallocate a portfolio. Individuals may want to recognize capital gains before the income is subject to the two-years-prior IRMAA rules.
Some strategies that retirees may want to contemplate in the years that are subject to IRMAA include timing the recognition of capital gains or harvesting tax losses, filing appeals for "life-changing" events, monitoring income levels to avoid the IRMAA "cliff," and using qualified charitable distributions (QCDs). With a QCD, taxpayers donate a portion of their IRA required minimum distribution. QCDs do not increase MAGI and therefore are not part of the IRMAA calculation. A QCD also offers a way for taxpayers taking the new, higher standard deduction to receive a tax benefit for charitable contributions without itemizing deductions on their income tax return (see "Tax Practice Corner: New Life for IRA Qualified Charitable Distributions," JofA, Oct. 2018). New retirees over age 65 may want to consider filing Form SSA-44 to avoid the IRMAA for the first two years post-retirement.
Other ways for new retirees to keep their MAGI below threshold levels include the sensible use of withdrawals from investment accounts that are nontaxable returns of capital, which are excluded from gross income, while still making withdrawals of enough taxable income to make full use of applicable deductions and nonrefundable credits. Other strategies include postponing distributions from qualified retirement accounts such as IRAs or Sec. 401(k) plans until the required age of 70½ and deferring Social Security benefits until age 70.
MINDING RETIREMENT FINANCES
All of the strategies to mitigate IRMAAs require special attention, and it is important for clients to consult with their CPA tax and/or financial adviser. A Roth conversion that pushes their tax bracket to 32% from 24% may not make sense to save a surcharge that effectively increases their household costs by 2% to 3%. However, pre-retirement income recognition may be wise if it can still permit clients to stay within the same income tax bracket for the current year, and their tax bracket will be the same or higher in their retirement years. It is imperative to employ a cost-benefit analysis with any tax or investment strategy.
Understanding health care costs is vital for successful retirement planning. Knowing about Medicare taxes, premiums, and surcharges is a good way to avoid unpleasant surprises and to help save clients' resources for better purposes. Superior results are generally obtained through planning.
About the author
Francis C. Thomas, CPA/PFS, is an emeritus professor of accounting and finance at Stockton University in Galloway, N.J. He is a financial adviser with CRA Financial LLC, an SEC Registered Investment Advisory firm, and a senior principal with Capaldi Reynolds & Pelosi Certified Public Accountants PA of Northfield, N.J.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.
- The Adviser's Guide to Financing Retirement Healthcare, aicpa.org (PFP Section member or PFS credential holder login required)
- Social Security and Medicare: Maximizing Retirement Benefits (#745614, text)
- Creating, Implementing, and Monitoring the Retirement Plan (#166451, online access)
- Elder and Special Needs Planning (#166461, online access)
- Retirement Planning Certificate Program (#166401, online access; #166481, online access and exam; #166470, exam only)
- "Social Security and Medicare: Maximizing Retirement Benefits" (#VCL4SSM19005, Oct. 2; #VCL4SSM19006, Nov. 7)
- Tax Tips: Getting Ready for Retirement, aicpa.org (member login required)
- Health Care Industry Conference, Nov. 6—8, Coronado, Calif. (#HEA19; online conference, #HEA19ON)
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