Don't overlook planning for health care during retirement

More than 40 years ago, author and futurist Alvin Toffler stunned the world with his predictions of rapid industrial and technological changes that would result in the information overload we all experience today. At some point decades in the future, aging baby boomers and their financial advisers may look back and wonder why they didn't heed today's warnings laid out in “What You Don't Know About Retirement Will Hurt You!” (People Tested Books, 2013), a self-published book by financial professionals Dan McGrath and Michael Gerali, and several of their like-minded colleagues. The book is based on the premise that planning for health care is the most overlooked component of financial planning and that Medicare will cost people a lot more than they think.

THREE RULES

The authors cite the three new rules of retirement: Medicare is mandatory, Medicare is means-tested and Medicare considers all but a few income sources to be includable in its means-testing formulas. They argue that traditional financial planning practices are on a collision course with skyrocketing health care costs in retirement. For those who didn't know that Medicare is mandatory: People 65 or older who sign up for Social Security benefits must sign up for at least Medicare Part A, which covers hospital costs. For those who wonder what the big deal is because Medicare Part A is free, just ask anyone who has a health savings account and takes advantage of tax-deductible contributions allowed when paired with a high-deductible health insurance plan. Once an individual signs up for Medicare, he or she can no longer contribute to an HSA. Those 65 or older must sign up for Medicare or they can't collect Social Security benefits. Medicare is means-tested. That means the higher a person's income during retirement, the more he or she will pay for Medicare Part B premiums, which cover doctors' visits and outpatient services, as well as Medicare Part D prescription drug coverage. The majority of Medicare beneficiaries pay the standard $104.90 per month for Medicare Part B coverage, and the premiums are deducted from monthly Social Security benefits. But those who are single and whose modified adjusted gross income tops $85,000, or married and whose adjusted income tops $170,000, will pay more, with surcharges ranging from $42 to $230.80 per month per person.

SURCHARGE

And those who earn just $1 more than the base income amount will be hit with a surcharge. As these base amounts aren't indexed for inflation, it is likely that more retirees will pay higher Medicare premiums in the future, thanks to annual cost-of-living adjustments in their Social Security benefits and investment growth that will lead to larger required minimum distributions from their retirement accounts. Given the fact that Medicare Part B premiums have been going up at a rate of more than twice that of projected Social Security cost-of-living adjustments, the authors predict that it is just a matter of time before Medicare premiums could consume a large portion, if not a majority, of a person's Social Security benefits. And that is under current law. There have been budget proposals to increase Medicare means testing until 25% of all retirees pay an additional surcharge above the basic monthly premium. The authors warn that traditional financial planning's emphasis on funding tax-deferred retirement accounts during one's career could lead to higher-than-expected health care costs during retirement. As Medicare premiums rise, retirees may be forced to take more money out of their tax-deferred accounts to maintain their lifestyle, boosting their taxable income and possibly pushing them into an even higher Medicare premium bracket. And even though their net Social Security benefits would be smaller, they would continue to be taxed on that phantom income. For Medicare premium purposes, income is defined as the total of adjusted gross income, plus any tax-exempt interest income. In addition to retirement plan distributions, income includes wages, the taxable portion of Social Security benefits, pensions, rental income, capital gains and dividends. “Basically, the traditional financial plan for income in retirement is going to be used against people when they retire,” the book says. But all isn't lost. A handful of investment products aren't counted as income by Medicare. They include distributions from health savings accounts, qualified distributions from Roth individual retirement accounts and Roth 401(k) plans, proceeds from a reverse mortgage, income from cash-value life insurance and certain distributions from annuities in nonqualified accounts. The authors offer some interesting financial planning solutions for young professionals who are decades away from retirement, as well as older clients who are on the cusp of Medicare eligibility. Rather than maxing out tax-deferred retirement savings, younger clients may want to contribute only enough to capture an employer match and divert other savings to vehicles that will produce tax-free income in retirement, such as a Roth 401(k) if available, a Roth IRA if income-eligible or permanent life insurance that can provide tax-free withdrawals or loans.

DEFERRED ANNUITIES

Clients in their 50s and early 60s may want to consider deferred annuities held in a nonqualified account that can act as longevity insurance and minimize taxable income in retirement without the restrictions of required minimum distributions. For those who can afford the tax bill, converting some traditional IRA funds to a Roth IRA account before Medicare eligibility may be wise. Although Mr. Toffler successfully predicted the emergence of the electronic frontier that we know as the Internet, as well as modern-day realities of cloning, Prozac and YouTube, he didn't get everything right. The authors of “What You Don't Know About Retirement Will Hurt You!” may also turn out to be only partially right. But I think some of their ideas about diversifying the future taxability of retirement income will stand the test of time. (Updated Jan. 20 to correct the Medicare Part B surcharge range.)