Financing Healthcare After Retirement
Probably one of the biggest concerns for people planning their retirement is having enough money. Directly related to this concern is the cost of healthcare. What will healthcare cost in retirement? Can I effectively manage the cost of healthcare? There is a lot that can be done to address the cost of healthcare through proper planning. How funds are saved and invested can play an important role.
Watch: Rick Rodgers explains The New Three-Legged Stool™ approach to efficient retirement planning.
Medicare plays an integral role in retirement healthcare costs. Medicare Part A, which covers hospitalization, has already been paid for through FICA taxes while the retiree was working. Medicare Part B covers doctor visits, emergency room visits, tests, and things of that nature. Part B premiums are usually deducted from Social Security benefits. Medicare Part D covers prescription drugs. Part D premiums are also deducted from Social Security benefits.
Finally, there are supplemental policies, also known as Medigap insurance. Medicare doesn’t cover everything, and estimates project only about half of someone’s medical expenses will be covered under Medicare. Most retirees need to purchase additional insurance to cover the remaining costs through a Medigap policy.
Medicare Advantage is a combination of Medicare Part A, B, D, and Medigap. The difference is that Medicare Advantage Plans is a way to get these benefits all in one policy, while Medigap is only a supplement to your Original Medicare Benefits. The premiums are deducted from Social Security benefits, but go to the Medicare Advantage provider instead of Medicare.
Healthcare costs for retirees have changed dramatically over the past 25 years, and more changes are likely coming. Most retirees didn’t buy Medigap policies in the past because their employer provided that coverage as a retiree benefit. That perk is slowly disappearing. Even when the employer pays some of the expense for company retiree healthcare, the retiree’s cost for Medigap coverage can make that more attractive. Fidelity has estimated an average retired couple age 65 in 2020 may need approximately $295,000 saved (after tax) to cover health care expenses in retirement1.
As time goes on, we should expect that retirees will be more responsible for their healthcare expenses. Average spending on deductibles has more than doubled from $130 in 2007 to $411 in 20172. It’s estimated that 18 percent of union workers had high-deductible plans available in 2017, compared with 45 percent of nonunion workers3.
In addition to these changes, national health spending is projected to grow at an average annual rate of 5.4 percent between 2019–2028 and reach $6.2 trillion by 20284. This comes at a time when retirees are expected to live even longer. A healthy 65-year-old couple planning for 25–30 years in retirement may have 30–35 years to live5. What might that mean in additional healthcare costs?
What Means Testing Means for Retirees
The government has chosen to address the increasing costs of Medicare through means testing. Upper-income retirees will pay higher premiums for Part B and D based on their income level. Medicare defines income level as Modified Adjusted Gross Income (MAGI). Retirees will not be able to get around this by investing in tax-free bonds. Tax-free income is included in MAGI. Means testing currently affects singles with income over $87,000 and couples with income over $174,000. For 2021, these thresholds are projected to increase to $88,000 for a single person and $176,000 for a married couple. The Part B premium for high-income beneficiaries is projected to range from $215/month to $521/month for retirees in the top income bracket6!
Retirees will need to pay close attention to means-testing levels to help contain healthcare costs. This requires careful planning before retirement. Strategies used in The New Three-Legged Stool™ to control income taxes can play an essential role in controlling Medicare premiums. The retiree who saves their money in a tax-deferred account will not only be forced to pay income taxes when they withdraw their funds: they could also pay higher Medicare premiums.
Striking a Tax-Efficient Balance
Our The New Three-Legged Stool™ strategy to retirement is based on balancing savings between tax-deferred, after-tax, and tax-free accounts. Many people are not concerned with balancing their savings. They save money in their company 401(k) for retirement and spend everything else. When these people enter retirement, they will have nothing but their tax-deferred savings to draw on. This will be coming when the IRS could be even more aggressive in taxing these assets on top of means testing Medicare premiums.
John Sample has done a perfect job of saving for retirement and has completely balanced savings. He has $667,000 in tax-deferred IRA/401(k) accounts, $667,000 in an after-tax account, and $666,000 in his Roth IRA tax-free account. His total retirement savings of $2 million can be expected to distribute 4 percent ($80,000) per year based on the prudent withdrawal rule. If all of Mr. Sample’s saving were in his taxable 401(k) and IRA accounts and he received $25,000 in Social Security benefits his Medicare premiums would be subject to means testing.
However, because Mr. Sample saved tax-efficiently, the after-tax account’s tax liability is not necessarily based on the amount of withdrawal. And there is no tax liability from any qualified Roth withdrawals. Assuming Mr. Sample follows the asset location strategy we recommend, there will be some tax implications from dividend distributions and rebalancing. Mr. Sample will only need to report $47,000 of taxable income from the account withdrawal. Therefore, he will pay less in income taxes, and his Medicare premium will not be subject to means testing.
Our The New Three-Legged Stool™ strategy provides a retiree with the flexibility to pull the income needed from the most tax-efficient location each year. This should become even more valuable as income taxes and Medicare premiums increase in the future.
- Medicare coverage is estimated to cover only 50 percent of healthcare expenses.
- Healthcare costs are expected to increase by 5.4 percent each year, which is more than twice the inflation rate.
- The New Three-Legged Stool™ strategy can be effective at reducing income taxes and minimizing Medicare premiums.
Originally published November 2015