Getting your retirement plan right isn’t just about determining a solid investment strategy. It covers a range of decisions, many of which impact other choices. And when you are living on income from investments and not salary, the stakes are a little higher. The decisions you make in retirement can be very costly if all the implications aren’t considered, and these negative consequences can persist for years.
While the big question for most people is “Will my nest egg last and provide the life I want?” we take a slightly different approach. Creating an investment strategy is just half the plan. The other piece is managing your assets and your income so that you pay as little in taxes as possible, and you avoid pitfalls like the Medicare Income-Related Monthly Adjustment Amount (IRMAA).
If you’re thinking that “income-related” sounds like a means test – you’d be right. The Medicare Part B and Part D premiums have an income component that assesses a surcharge. Using 2021 numbers, depending on your income, the standard monthly Medicare Part B premium of $148.50 can increase to $504.90, and the Part D premium can have as much as an additional $77.10 tacked on.
We explain how this works, what it means for you, and provide some thoughts on creating a tax-focused retirement plan that can help you avoid it.
Understanding the Medicare Surcharge
The surcharge increases are tiered and correspond to different income levels, from the first one at income of $176,000 for a married couple up to income over $750,000. But it’s not as easy as keeping your income at a consistent level. There are two wrinkles.
- The surcharge is based on a calculation of Modified Adjusted Gross Income (MAGI) specific to Medicare, and different from AGI and other calculations of MAGI. It includes income that would otherwise be tax-exempt, such as income from state and local bonds.
- There’s a two-year lookback, meaning that 2021’s premium surcharges were determined by income in 2019. There’s also no smoothing – if you have unusually large income in any given year, for example from the sale of a business or other asset, you could get hit with the surcharge two years later.
And just for the icing on the IRMAA cake, beginning in 2020 the MAGI income requirements will be adjusted for inflation each year.
Here’s the whole breakdown of the Part B premium surcharges for 2021. As you can see, the premiums go up significantly in each tier, so missing any of the cutoffs even by hundreds can result in paying thousands more in premiums.
2021 Medicare Part B Premium Rates:
|You Pay||If your 2019 income was:|
|Premium||PART D Surcharge||SINGLE||MARRIED COUPLE|
|$115.48 Hold Harmless
$148.50-not Hold Harmless
|$88,000 or less
$88,000 or less
|$176,000 or less
$176,000 or less
|$207.90||$12.30||$88,001 – $111,000||$176,001 – $222,000|
|$297.00||$31.80||$111,001 – $138,000||$222,001 – $276,000|
|$386.10||$51.20||$138,000 – $165,000||$276,001 – 330,000|
|$475.20||$70.70||$165,001 – $500,000||$330,001 – $750,000|
|$504.90||$77.10||Above $500,000||Above $750,000|
But Aren’t Health Insurance Premiums Tax-Deductible?
Yes, and since Medicare Part B is considered “optional” it can be deducted. You’ll need to itemize deductions, and your medical expense deductions must be more than 10% of AGI. So, while you can recoup some benefit from the additional cost, avoiding as much of it as possible in the first place may be a better strategy.
Managing IRMAA Comes Down to Managing Income
Once you determine your budget for retirement spending (that’s another whole blog), the next step is funding it. That’s where the tax plan comes in. As we’ve seen above, income from investments that will count towards AGI, and therefore MAGI, can have greater consequences than just a bigger tax bill.
But even if you’ve determined a strategy that throws off consistent income and allows you to maintain enough invested for growth, if your assets are held in tax-deferred accounts, you don’t have as much control over income as you think. Starting at age 72, you’ll have to take required minimum distributions from your 401(k) or IRA accounts. The amount you are required to take out is pegged to both the account’s value and your life expectancy – so in most cases, it goes up every year.
A Potential Solution: The Roth Conversion
The idea behind the Roth account is that you put money away early in your career when your tax rate is lower than it will be in retirement. The Roth conversion turns that around. Because taxes are likely to go up, paying the initial tax in early retirement can mean that over the course of a multi-decade retirement, you’ll save some on taxes. But the real benefit is that because you pay the taxes upfront, the funds aren’t taxable when they are withdrawn. This gives you control over your income stream, so you can keep it at levels that can minimize or eliminate the Medicare IRMAA.
Other benefits include keeping your money invested and working for you when markets are going up and avoiding crystallizing losses when markets go down. And they make a good estate planning tool, since the restrictions on inherited tax-deferred accounts don’t apply. The sweet spot for doing a Roth conversion is early retirement, before RMDs kick in. If you can do it before you sign up for Medicare – even better, as you’ll be bumping your income up in the years in which you convert funds.
While the Build Back Better Act has some proposed plans to potentially eliminate Roth conversions, even if enacted they won’t go into effect until 2030.
The Bottom Line
If you’re only thinking about creating an investing plan that will provide income, you may be leaving money on the table when it comes to taxes – and you may be increasing your expenses. A good retirement plan is thorough, flexible and considers both income and taxes.
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