Warning: RMDs can trigger massive surcharges for health insurance tests

Editor’s note: This is part three of a seven-part series. It dives deeper into how high income from Required Minimum Distributions (RMDs) can cost retirees hundreds of thousands of dollars in Medicare supplements. If you missed the introductory article, you might find it useful to start here.

No one wants to pay hundreds of thousands of dollars or even over a million dollars more than they owe for Medicare in retirement. But due to means testing, that’s what could happen if you’re a diligent saver hiding every penny you can in your 401(k) or other pre-tax retirement savings account.

This article is a summary of a groundbreaking white paper I published in 2019, in case you want to dig deeper into the history and mechanics of Medicare Means Testing. All background data cited in today’s Medicare article can be found in the 2019 article.

How health insurance premiums work

Traditional Medicare services include Part A (hospital care), Part B (doctor), and Part D (prescription drugs) coverage. Many retirees mistakenly think Medicare is free because they have paid Medicare taxes into the system for their entire working life. But for most retirees, only Part A is free, while Part B and Part D have monthly premiums, usually deducted from retirees’ Social Security checks.

As my white paper indicates, Medicare Part B costs rose 8.8% per year from 1970 to 2019, an incredibly high rate over an extended period. This is similar to the inflation rates we experienced in 2002, but rather over a 49-year period. High compound inflation rates like this can have a devastating impact over time.

The government subsidizes Medicare costs by setting the base premium at 25% of projected per capita costs, meaning the government covers the remaining 75% for most (but not all) retirees. Despite the subsidies, significant cost increases have been passed on to retirees. Medicare Part B base premiums increased 7.5% per year from 1966 to 2019 (from $3.00 per month to $135.50 per month). By comparison, the core annual inflation rate (at least until 2019) has been around 2.3%.

Medicare itself faces even more severe solvency problems than Social Security. The only way to improve Medicare solvency is to raise taxes, cut benefits, or run bigger deficits. It is not a political statement. It’s math. And that’s why, as of 2019, Medicare administrators expected Medicare Part B premiums to increase an average of 5.17% per year from 2020 to 2027.

What is Medicare Means Testing?

Following the 2003 legislation, the government began to reduce the subsidy for high earners, forcing them to pay higher premiums on Part B and Part D from 2007. These higher premiums are known as Income-Related Monthly Adjustment Amount (IRMAA) surtaxes or “means test.

The chart below shows Part B and Part D premiums for 2022 (Part D premiums are for a plan in Austin, TX). Premiums are tied to the modified adjusted gross income of the previous two years, so 2022 rates use 2020 income. Premiums for highest earners versus lowest earners are 3.4 times higher for part B and 4.4 times higher for part D.

At higher income levels, the government reduces the per capita federal subsidy, forcing retirees to bear more of the cost. From 2007 to 2019, the base bonus increased by 3.1% per year, while bonuses for resource levels increased from 5.0% to 8.6% per year.

The means-testing concept should come as no big surprise because the most politically acceptable way to improve Medicare finances is to make the wealthiest people pay more. All signs suggest that the tests will become more severe over time.

From 2009 to 2019 the income brackets were not indexed to inflation and in some years the government even reduced the income brackets. So over time, more and more people got tricked into resource testing. Starting in 2020, income brackets were indexed to inflation, which was good news for retirees, but the government could easily stop inflation adjustments to help balance Medicare’s books.

MDM and Medicare Means Review

Recall last week’s article on RMDs, the case study of a 40-year-old couple who saved a combined $500,000 in pre-tax retirement accounts and continue to maximize pre-tax contributions until retired at age 65.

The couple’s tax-deferred retirement accounts hit $11.9 million at age 72, when they take their first taxable RMD of $435,820. The RMD snowballs to $1.3 million in taxable income at age 90.

In the table above, the couple should be in test level three from 74 to 76 and level four from 77 to 90. Their total “base” Medicare Part B and Part D premiums from age 65 to 90 are projected at $856,526 (in future dollars, with each income bracket inflated using Medicare’s historic inflation rate of 5.17% in 2019). However, the couple will face an additional $1.5 million in additional Medicare testing costs until they turn 90.

So far, this series has looked at how tax-deferred savings can create RMD income problems and Medicare mean test surtaxes. My next article will focus on problem #3: inherited tax debts.

Partner, Forum Financial Management

David McClellan is a partner at Forum Financial Management, LP, a registered investment adviser that manages over $7 billion in client assets. He is also Vice President and Head of Wealth Management Solutions at AiVante, a technology company that uses artificial intelligence to predict lifetime medical expenses. Previously, David spent nearly 15 years in senior roles at Morningstar (where he built retirement income planning software) and Pershing. David is based in Austin, Texas, but works with clients nationwide. His practice focuses on financial life coaching and retirement planning. He frequently helps his clients assess and defuse retirement tax bombs.

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