By now, every savvy advisor recognizes that health-care is an essential consideration in retirement planning. People are living longer than they used to and, consequently, relying on expensive life-saving treatments for years, even decades. Meanwhile, medical costs keep rising faster than inflation.
Dire as this may sound, new Medicare regulations make the situation even more challenging—often catching retirees and their advisors by surprise.
“Unfortunately, too many Americans are under the mistaken assumption that government programs—in their current form—have evolved to adequately meet the needs of boomers heading into retirement,” says Mike Padawer, president of INERTIA/Advisor Services Group, a long-term-care advisor in St. Louis. “Whether it’s Medicare or Social Security, neither was designed to meet the demands of the increasing life expectancy we see today.”
So what can advisors do?
How Medicare Works
First, understand how the four different parts of Medicare work. Part A, which covers hospital expenses and is mandatory, is paid through a payroll tax. The more you earn pre-retirement, the more you pay into it; the amount you get out at age 65 or with certain disabilities depends on your health. Part B, for outpatient services, requires Medicare participants to pay a premium that is greater for individuals who are considered to have high income. Part C refers to Medicare Advantage Plans—a variety of optional, privately run insurance plans that replace or supplement the standard government-run benefits. If a beneficiary does not have Medicare Part B, they are not eligible for Medicare Part C, also called Medigap coverage.Finally, Part D, launched in 2006 to expand coverage of prescription drugs, is also optional and funded by individual premiums.
Under current and pending federal budgets, Medicare parts A, B and D could start costing people more.
Part A: Hospitals
A payroll deduction of 2.9% (typically divided equally between employer and employee) funds both Medicare Part A and Social Security. Beginning this year, however, with passage of the Affordable Care Act, those who earn more than $200,000 in wages ($250,000 for couples) pay an extra 0.9%, or 3.8% total. In addition, a separate 3.8% will be taken from unearned income or investment income that exceeds those same levels.
If you think this means only the wealthiest will be affected, think again, experts caution. The definition of unearned income is broad. “The required minimum distributions from [tax-deferred] plans, when added onto Social Security and pension income, can easily make middle-class retirees wealthy in the eyes of Medicare,” says Robert Klein, a financial advisor with Investors Capital Corp. and Investors Capital Advisory, both in White Plains, N.Y.
A commonly suggested solution to this 3.8% levy on investment income is to move assets to municipal bonds. “Municipal bond dividends are excluded from the tax,” says Klein. “But here’s the catch—muni income counts toward your modified adjusted gross income, which is part of the ‘means testing’ for Medicare parts B and D. So the government gives with one hand and smacks you with the other.”
Part B: Outpatient Care
Unlike Part A, Medicare Parts B takes premium payments from subscribers, payments usually deducted from Social Security payouts. In 2012, the premium was raised for individuals with a MAGI of $85,000, or double that for couples. The higher the MAGI, the higher the premium.
Now, several budget proposals—notably, from the White House; the House Ways and Means Committee; and the Bipartisan Policy Center, a Washington, D.C.-based think tank—aim to raise the premiums, perhaps even by lowering that minimum threshold to $65,000 per person. “The proposed budgets going forward would expand means-testing by either adding more income brackets, lowering the income thresholds, or raising the percentage of Medicare premiums paid by higher income individuals,” says Michael C. Gerali, a partner at the Lakewood, Colo.-based Parapet Group LLC.
Even if these changes don’t come to pass, the premium threshold could take a nasty bite. “Because it is not currently indexed for inflation, this number is actually decreasing every year when it comes to purchasing power,” says Gerali. “In addition, anyone selling a home or [other] assets might find themselves in a higher bracket because these transactions could add to a person’s post-retirement MAGI.”
Gauging The MAGI
Advisors should be aware how easily and quickly even middle-class clients can fall into this Medicare peril. “It will ultimately impact whoever is deemed to have too much definable income,” says Dan McGrath, founder and director of health-care funding strategies at Jester Financial Technologies and the Parapet Group, both in Windham, N.H. “In order to understand who this will impact, you must first understand what is defined as part of MAGI.”
To compute the MAGI, you add ordinary adjusted gross income to tax-exempt interest income. “Wages, tips, interest, capital gains, Social Security, dividends (including those from muni bonds), withdrawals from 401(k)s/403(b)s/Keogh accounts/SEP IRAs/traditional IRAs, and income from most annuities,” says McGrath. “Everything on lines 8b and 37 of IRS Form 1040.”
This means many tax-deferred savings strategies could end up costing clients plenty.
Tools For Avoiding Medicare’s Bite
Yet there are income vehicles that are exempt from MAGI consideration. Roth IRA conversions; borrowing against certain life insurance policies; reverse mortgages; some non-qualified annuities with high-exclusion ratios; and distributions from qualified 401(h) post-retirement medical benefit plans, health savings accounts and voluntary employees’ beneficiary associations (i.e., tax-free post-retirement medical-expense accounts funded by the retiree’s unused sick leave) are good sources of retirement income that aren’t subject to Medicare penalties.
There is also a residence-sale exclusion. If a retiree sells his or her principal residence, the first $250,000 per person (or $500,000 for couples) is not part of the MAGI calculation. “They must have owned and used the home as a principal residence for at least two of the preceding five years, and not also excluded the gain from the sale of another home in the prior two years,” says Justin S. Belair, an attorney and certified financial planner at the law firm Gould & Gould in Londonderry, N.H.
Furthermore, a cash-value life-insurance policy can become a key part of a tax-free retirement income stream, especially if it’s been “funded aggressively enough for long enough, [say] 15 to 20 years,” says Bob Ryerson, a certified financial planner at New Century Planning in Freehold, N.J. A life insurance loan schedule will “not show up on the IRS’s radar [or] count in MAGI or affect Social Security taxation,” he says. It also will never decline in value, unlike a Roth IRA. “The added benefit is you aren’t confined to just that annual amount. [It provides] flexibility for when life offers a great opportunity or throws you an emergency curveball!”
By utilizing these sorts of strategies, you can greatly reduce your client’s exposure. “Create a plan with these types of investments and products, tie in a long-term-care rider or LTC hybrid policy … and amazingly, everything should be all right,” says McGrath, adding, “Income in the wrong form is not your friend, but your worst enemy.”
Part D: Prescription Drugs
Medicare Part D, the other means-tested optional premium, is subject to many of the same considerations. Those above the income threshold are facing a higher premium. But some advisors note they may pay less at the pharmacy than in years past.
In general, retirees on Medicare Part D must pay for their medications until they reach their deductible. Because Part D offers different drug plans, the exact deductible amount varies. In 2014, the maximum annual deductible is $310. Then the plan kicks in, covering roughly 75% of medication costs.
But once your client pays about $635 and the plan pays about $2,215 within a calendar year, the reimbursement rate drops off considerably. In 2014, however, individuals have to pay 47.5% for brand-name medications until they spend $4,550 for the year. Then the plan picks up a bigger portion of drug purchases again, often leaving as little as 5% for the client to pay out-of-pocket through year-end.
“This ‘doughnut hole’ will gradually close,” says Kristen Fricks-Roman, a financial advisor and senior vice president at Morgan Stanley in Atlanta. “By 2020, seniors will only be required to pay 25% of the prescription-drug spending within the doughnut hole. So while the wealthy may pay a higher Part D premium, they may also pay less in out-of-pocket prescription drug costs.”
Ostensibly, the idea behind raising premiums and expanding means-testing, as well as increasing Medicare Part A taxes, is to keep the system solvent. But skeptics say these measures won’t accomplish that because they miss the heart of the problem. “Given the aging of the Baby Boomers, spending on Medicare is expected to rise significantly over the next 20 years, and the challenge cannot be solved by simply increasing taxes or premiums for a small percentage of recipients,” says Shannon Reid, director of retirement solutions at Raymond James Financial in St. Petersburg, Fla.
Better solutions may lie in the hands of government, but it’s plainly a nonpartisan issue. McGrath points out that Medicare Part A became mandatory in 1993 under a Democratic administration. Means testing for Part B was put in place in 2003 under Republican rule. It was expanded to Part D in 2011 under Democrats. And so forth. “Both sides seem to be in it to win it, and the opponents are our retirees,” he says.