Retirement Income Strategies for Rising Medicare Premiums
We recently wrote about Medicare premiums and discussed how high earners may be affected by those premiums. The premiums can be substantial and can have a huge impact on a retiree’s discretionary income. You can click here to read the previous article. This article is “part 2” of that article and discusses ways to lower your modified adjusted gross income “MAGI” in retirement in order to minimize your Medicare premiums.
As our previous article mentions, Medicare premiums can be significant; however, there are a few ways to keep premiums at a minimum. Initially, you must understand what income is considered in determining your MAGI. MAGI is similar, but not identical, to your adjusted gross income “AGI”, which can be found on line 37 of your Federal Form 1040. To reach MAGI, you start with AGI and add to it your tax-exempt interest income.
Another point that individuals may not realize is that the government typically isn’t looking at current year income when calculating your MAGI. This is so because the Social Security Administration will look at the most recent tax return provided to them by the Internal Revenue Service. This return will not be for the year in which you apply for benefits, and it may not be for the previous year depending on when you filed your previous year return. For example, if you are applying for Medicare benefits in 2015, it is possible that the government will look at your 2013 income to determine your 2015 Medicare premiums. Knowing this, if you plan to retire at age 65, you might need to start looking at your MAGI when you are 63. If you are close to the top of a Medicare premium bracket, you might want to dig deeper into your MAGI to determine what your premiums will be. This also might affect individuals working past age 65. If you are working until age 70, you might have to look at your earnings at age 68 to make sure you aren’t adding unnecessary cost in Medicare premiums.
A possible strategy to avoid increasing your Medicare premiums is tactically taking capital gains, which are included in your MAGI. For example, if you are only a few thousand dollars away from hitting the next highest tax bracket for Medicare premiums and it is December, why not wait until the new year to sell those investments to avoid the extra cost in premiums! Another strategy would be to defer taking Social Security benefits for as long as possible. As up to 85% of Social Security benefits can be included in your MAGI, adding these benefits increases your MAGI and potentially the cost of your Medicare premiums. Deferring your Social Security benefits also allows your benefits to grow by 8% per year – a strategy that makes a lot of sense given the extremely low interest rate environment we are in right now.
A fourth strategy to consider is a Roth conversion. Many individuals have large tax-deferred account balances, having saved during their entire working career into their employer retirement plan. Once these individuals retire, they then typically rollover those balances into an individual retirement account (“IRA”). Having large tax-deferred account balances ultimately leads to large required minimum distributions (“RMD”) once you reach age 70 ½. To combat this potential problem, you could convert some of your traditional IRA to a Roth IRA in years when income levels are low. For example, let’s take an individual who has the luxury of retiring at age 60 and doesn’t have a need for a lot of income. This person can arrange his or her income stream to the point that his or her taxable income is close to zero. This may be done by taking distributions from Roth accounts or taxable accounts that don’t have large capital gains built in. When converting, the Roth conversion amount will be included in income, but since taxable income is low, the tax rate on the conversion will be at a minimum. In some cases, you can transfer thousands of dollars from a traditional IRA to a Roth IRA while staying in the 15% marginal income tax bracket or lower.
These Roth conversions have multiple benefits. First, it lowers your RMD since your account balance will be reduced as a result of withdrawing money for the conversion. This in turn will lower your chances of bumping you into a higher Medicare premium bracket. Another benefit in doing this is it gives you flexibility in retirement when distributing assets. As we know, the Medicare brackets are cliff brackets. If you are close to one of the brackets, and you know another $5,000 of income will push you into a higher bracket, the cost of needing anything over $5,000 could be a lot more than a dollar for dollar. If you need a new roof and it costs $5,001, that extra $1 will cost you thousands in Medicare premiums. Instead, if you had a Roth account, you could draw from this account and this income is not considered part of MAGI for Medicare premium purposes. You can see how the flexibility of having a Roth account can add value to your overall wealth.