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’s a lot that can be done to manage the cost of healthcare through proper planning. How funds are saved and invested will play an important role.
Watch: Rick Rodgers explains The New Three-Legged Stool™ approach to efficient retirement planning.
Medicare plays an important part in retirement healthcare costs. Medicare Part A, which is 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, or Medigap insurance. Medicare doesn’t cover everything. Estimates project only about half of someone’s medical expenses are covered. Most retirees need to purchase additional insurance to actually cover the remaining costs through a Medigap policy.
Medicare Advantage is a combination of Medicare’s Part A, B, and D and Medigap. The difference is that Medicare Advantage is primarily an HMO, where Medigap is primarily a PPO. 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 coming. Most retirees didn’t buy Medigap policies in the past because their employer provided that coverage as a retiree benefit. That perk is either going away completely or the cost shared by the retiree makes buying their own Medigap coverage more attractive. Fidelity has estimated the cost of supplement insurance and out-of-pocket prescription costs at $260,000 – $270,000 during retirement.
We should expect that as time goes on retirees will be more and more responsible for their own healthcare expenses. Deductibles for preretirement commercial insurance have increased by some 50% over the last ten years. It’s estimated that 20% of the working population is already in a high deductible plan.
In addition to these changes, healthcare costs are projected to inflate at 6 – 6 ½% going forward. This comes at a time retirees are expected to live even longer. The Society of Actuaries projects that life expectancy increases a little more than a month each year. A healthy 65 year old couple planning for 25-30 years in retirement may actually have 30-35 years to live. What might that mean in additional healthcare costs?
The government has chosen to address the increasing costs of Medicare through means testing. Upper income retirees will pay higher premiums for Part B & D based on their income level. Income level is defined by Medicare 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 $85,000 and couples with income over $170,000. These income levels are not indexed to inflation. The Center for Retirement Research at Boston College projects Part B premiums could jump from the current standard monthly premium of $104.90 to $510 for retirees in the top income bracket!
Retirees will need to pay close attention to means testing levels in order to contain healthcare costs. This requires careful planning before retirement. Strategies used in The New Three-Legged Stool™ to control income taxes will play an important role in controlling Medicare premiums. The retiree who saves all of their money in a tax deferred account will not only be forced to pay income taxes when they withdrawal their funds, they could also pay higher Medicare premiums.
The New Three-Legged Stool™ approach to retirement is based on balancing your savings between tax-deferred, after-tax and tax-free accounts. Many people are not concerned with balancing their savings. They save money in the 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 at a time 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. $667,000 is in tax-deferred IRA/401(k) accounts. $667,000 is in an after-tax account and $666,000 is in his Roth IRA tax-free account. His total retirement savings of $2 million can be expected to distribute 4% ($80,000) per year based on the prudent withdrawal rule. This income, if everything was in his 401(k) and IRA accounts and was all taxable, together with Social Security benefits of $25,000 would make his Medicare premiums subject to means testing.
However, because Mr. Sample saved tax efficiently the tax liability from the after-tax account 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.
The New Three-Legged Stool™ approach 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% of healthcare expenses.
- Healthcare costs are expected to increase by 6-6 ½% each year which is more than twice the rate of inflation.
- The New Three-Legged Stool™ strategy is effective at reducing income taxes and minimizing Medicare premiums.