There’s a lot to think of during retirement, especially when it comes to managing your income and your tax burden. If you are retired (or getting close to retirement), tax-efficient income planning can make a big difference, especially when it comes to Medicare premiums.
A Quick Refresher on Medicare Premiums
If you’re retired with health insurance through Medicare, your premiums are directly related to your income. Medicare beneficiaries pay a premium for Medicare Part B (which covers doctors’ services) and Medicare Part D (which covers prescription drugs). For most retirees, premiums cover about 25% of program costs for Part B and D and the government pays the other 75%.
What is IRMAA?
Medicare imposes an extra charge for higher-income beneficiaries. “The theory is that higher-income beneficiaries can afford to pay more for their healthcare. Instead of doing a 25:75 split with the government, they must pay a higher share of the program costs.”
In other words, the higher your income, the higher your premiums will be. These extra charges are called Income-Related Monthly Adjustment Amounts (IRMAA).
The income used to determine IRMAA is modified adjusted gross income (MAGI). MAGI is adjusted gross income plus any municipal or tax-exempt bond interest. IRMAA is based on your most recent tax return filed, which is often two years prior to the year IRMAA might apply. For example, your 2020 tax return is used to calculate IRMAA and Medicare premiums in 2022. Your 2021 income will determine your IRMAA in 2023, and so forth.
How Does Income Affect IRMAA?
IRMAA is divided into five income brackets. Depending on your income, you may pay 35%, 50%, 65%, 80%, or 85% of program costs instead of 25%. These brackets are not progressive brackets like the federal tax system. Crossing into a higher bracket by just $1 could mean paying thousands in additional Medicare premiums. Because your IRMAA is based on income from two years ago, it must be recalculated each year.
Why Income Planning is Important
Keeping Medicare premiums in mind while income planning can make a big difference. For individuals bringing in around $91,000 and couples filing jointly $182,000 or more, additional income may raise their federal and state tax liability and increase the premiums they pay for Medicare. In essence, IRMAA works similarly to an additional tax.
Planning around IRMAA isn’t easy because income today (in 2022) will dictate what premiums and potential IRMAA you pay in 2024. If you are unsure of how your income might affect your Medicare premiums, we are able to help you understand it by reviewing your tax return. This requires careful consideration of several factors, such as cash flow needs and inflation assumptions.
When thinking of making a financial decision that could result in more taxable income, it is important to consider how it could affect IRMAA in future years. Roth conversions, IRA distributions, wages, and capital gains are all common examples of things that may increase modified adjusted gross income (MAGI), on which IRMAA is based.
Income Planning Example
Let’s walk through an example to help put IRMAA and Medicare premiums in perspective.
Jonathan and Margaret Doe are both age 66. First, let’s calculate their MAGI.
- Combined Social Security of $60,000 ($51,000 taxable SS benefits)
- Pension of $80,000
- IRA distributions of $60,000
- Muni bond income of $10,000
Total gross income = $191,000
Adjusted gross income (AGI) = $191,000
Modified adjusted gross income (MAGI) = $201,000 (AGI + the $10k municipal bond interest)
Jonathan and Margaret need $30,000 of additional income to renovate their lakeside cottage and are considering upping their distributions from an IRA to cover the costs.
If taken from a pre-tax IRA, the extra $30k would create an additional federal tax liability of roughly $7,000 or 23.33%. This would also bump the couple into the third tier for IRMAA and cause additional Medicare premiums of $170/month per person or $4,080 for the year. Added together, the additional $30,000 in IRA distributions could result in the couple paying $11,080 between federal tax and IRMAA charges which equates to a marginal tax cost of 36.9%.
Thankfully, Jon and Marge know the value of careful financial planning. After discussing things with their financial advisor, the couple is considering pulling cash from non-taxable accounts or splitting the distribution over multiple years.
Plan for a More Confident Financial Future
A little careful planning can go a long way to help you avoid unnecessary taxes and Medicare surcharges. At Midwest Capital Advisors, we build customized financial plans designed around each individual and their financial goals. Contact us anytime if you’re planning for your retirement years or are already retired and have questions about how to structure your income more tax-efficiently. Our advisors are here to help you plan for a more confident financial future.