Health Care in Retirement Before Medicare
If you’re considering retiring before you’re eligible for Medicare, but aren’t sure you’ll be able to purchase affordable health care during that time, this white paper is designed for you. By carefully selecting how and when you take various forms of retirement income, you can potentially save thousands of dollars in health insurance costs.
The Affordable Care Act
The Affordable Care Act (ACA) put in place comprehensive health insurance reform that has improved access, affordability, and quality in health care for many Americans.¹ It has also opened a bevy of options for individuals who have been diligent savers throughout their working years and are entertaining the possibility of retiring prior to turning age 65, at which point they would be eligible for Medicare.
One of the key components for reducing your health care cost, related to the Affordable Care Act, is to reduce your Modified Adjusted Gross Income (MAGI). This can be reduced during your retirement years by using a few different strategies:
- Delay taking your Social Security income
- Delay taking your pension in select scenarios
- Maximize deductions
- Plan to have a sufficient amount of money in the proper types of investments and have an effective distribution strategy from those investments.
Before understanding the distribution strategies associated with health care cost reduction, it is important to understand how the different savings, retirement accounts, and investments are taxed.
Understanding the Three Tax Buckets
Imagine you had to fit all of your investments into one of three buckets: The Taxable bucket; the Tax-Deferred bucket; or the Tax-Free bucket.
The Taxable bucket includes any type of investment for which you receive a 1099 on an annual basis. These funds receive no special tax treatment, and you will typically be taxed on interest and dividends as they are paid, in addition to any gains you make upon sale of investments in this bucket.
The Tax-Deferred bucket includes any retirement accounts to which you have contributed money on a tax-deductible or pre-tax basis. These accounts typically allow for tax-deferred growth, which means that you are not taxed on income or gains as they occur, but when you eventually take retirement income, the funds you withdraw will be taxed as ordinary income.
Finally, the Tax-Free bucket includes accounts to which you contribute with after-tax money; you do not get any special tax breaks up front in this bucket, but all contributions and growth can be withdrawn income tax-free for qualified reasons.
Each of these different buckets has their own unique characteristics. Some are more suited for certain needs than others, so it is important to plan accordingly.
Now that you have a good understanding of how the different tax buckets work, let’s look at which of these buckets are friendly if you choose to select health care from the Affordable Care Act (ACA) Marketplace.
Using the Tax Buckets for Health Care Planning
The Taxable bucket, also what we call the non-qualified bucket, may be a good option if you do not want to show income when distributions are taken. There are caveats to this, however. If you have highly appreciated assets that you sell, like stocks, any capital gains from those stocks would count as taxable income, which could potentially decrease your ACA tax credits.
It’s important to be careful with the types of investments that you select for this bucket. It’s also important to take distributions from the proper investments within this bucket. When done correctly, this may be a way to fulfill your income needs without disqualifying you from tax credits.
The Tax-Deferred bucket, which includes things like IRAs and workplace retirement plans, typically is not a friendly place from which to take your income, and frequently, 100% of the distributions from this bucket will count towards your modified adjusted gross income (MAGI).
The Tax-Free bucket, which includes Roth IRAs, Roth 401(k)s, and other Roth work retirement accounts, can be a very friendly place from which to take distributions as it pertains to health care planning because qualified distributions from this account do not count towards your modified adjusted gross income.
In essence, it is extremely important that, prior to retirement, you take careful consideration as to how you organize these various buckets and include an appropriate amount in the tax friendly buckets. This may help you reduce your health care cost by maximizing your ACA tax credits.
Helpful Info: What is a “Qualified Distribution”?
A qualified distribution from a Roth IRA includes all contributions and growth on those contributions, provided the growth has remained in the account for 5 years from the first contribution date or you are at least age 59.5, whichever is later. Any conversions from IRA to Roth IRA may also be considered a qualified distribution; however, any growth on each converted amount must remain in the account for at least 5 years or until age 59.5, whichever is later.
How this works in real life – Hypothetical Examples
Now let’s take a look at a few hypothetical case studies.
Case Study #1
Let’s assume John and Jane Smith are 62 years old. They recently retired and need $100,000 to live on. They have their retirement savings broken down as follows:
- $300,000 in the non-qualified bucket–we will assume this is sitting in savings accounts with their bank
- $1.5 million in their tax-deferred bucket
- $0 in their tax-free bucket
One strategy to consider for them is to delay taking Social Security, which would provide them with two benefits:
- It won’t count as modified adjusted gross income (MAGI), and therefore, may qualify them to receive increased tax credits.
- They also would continue to build their Social Security benefit so when they do start taking Social Security income after they hit Medicare age, they would get a higher amount for the rest of their lives.
In addition, another strategy would be to take income from friendly tax buckets. To help them meet their income needs they could withdraw approximately $80,000 per year (from 62 until 65, at which point they are eligible for Medicare) from their non-qualified bucket, none of which would be counted as modified adjusted gross income. Then they may want to take $20,000 from their tax-deferred bucket, which would show up as modified adjusted gross income.
The reason that they would want to take $20,000 as taxable income is that if their income is too low, they may not qualify for the Affordable Care Act insurance; instead, they may qualify for some sort of medical assistance program and may have the quality of their health care compromised.
Case Study #2
For case study number two, we have Bob and Laurie Jones. They’re 62 they recently retired and they have income needs of $100,000 per year. They have their retirement savings broken down as follows:
- $40,000 in the non-qualified bucket–we will assume this is sitting in savings accounts with their bank
- $1.5 million in their tax-deferred bucket
- $300,000 in their tax-free bucket and various Roth IRA accounts
One strategy that they could consider is again, taking $20,000 a year from the tax-deferred bucket, which would show up as modified adjusted gross income, but would keep them from qualifying from medical assistance.
Then, they could take the remaining amount from their Roth IRA accounts, assuming the withdrawal is a qualified distribution.
And again, they would want to delay taking their Social Security for the same reasons mentioned previously.
The Impact of These Strategies on Health Care Premiums
Let’s see how the strategies from our first two case studies impact the health insurance premiums they would potentially pay with their lowered MAGI. By modifying their retirement income sources, they may be able to receive as much as $2,617 per month in premium tax credits, which equates to annual savings of $31,399.32.²
If they continue doing this for three years until Medicare starts at age 65, they would potentially save in excess of $78,000 in healthcare costs.
Case Study #3
With case study number three, let’s assume Mark and Joy Anderson are age 60. They’re planning to retire in two years and their income needs are $100,000 a year. They have very little in the non-qualified bucket to use for income and very little in their tax-free bucket.
In this circumstance, it would be very important for them to look at every strategy possible to get money into the tax-free or non-qualified buckets. This could be accomplished through contributions into those buckets or by converting money from the tax-deferred bucket to the tax-free bucket.
What About Work Retirement Plans?
In addition to the Traditional IRA and Roth IRA accounts, many individuals have access to saving for their future retirement through a 401(k), a 403(b), or a 457(b) retirement plan. Although there are some differences between these types of plans, I would like to focus on how they are similar.
First of all, these types of plans typically allow employees to invest a portion of their paycheck in a tax-deferred manner. Often the employee has control over how the funds are invested, limited by the funds available within the retirement plan, and sometimes there will be an employer matching contribution. These accounts can help individuals save, but there are plenty of restrictions and caveats: early withdrawal penalties and vesting requirements, to name just a couple.
Remember I mentioned how diversifying savings investment accounts may provide increased flexibility in determining when retirement is a viable option? For the sake of this article, I want you to consider 401(k)s, 403(b)s, and 457(b)s as being bunched together in the same bucket as the Traditional IRA accounts. What I mean by this is that income from the aforementioned accounts works similar to the IRA: distributions are taxed as ordinary income. While you’ve been working and saving, the accounts have been growing on a tax-deferred basis; however, withdrawals will affect your taxable income.
The best-case scenario would be an individual who has saved diligently into all three “buckets” (non-IRA, IRA, and Roth IRA) throughout his/her working years. This person would have potential flexibility in structuring his/her retirement income so that the taxable portion is within the guidelines of the Affordable Care Act resulting in attractive tax premium credits, saving potentially thousands of dollars in health care costs per year.
Without Diversification, Early Retirement May Be Less Viable
Without the diversification in account types, it becomes more difficult to control the cost of health care, making early retirement potentially less viable. As each person gets closer to retirement, it may become more difficult to implement the diversification of account types due to contribution limits (IRA and Roth IRA) and lack of “extra funds” outside of annual household needs. This is why it is imperative to start account diversification early.
Talk to a Financial Professional
If you’re trying to figure out if early retirement is a viable option for you, it’s best to talk to an experienced financial adviser who can help you determine which strategies may work better for you than others. Please contact us if you’d like a complimentary consultation.