Don’t Let IRMAA Crash Your Retirement Party

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“To quote those commercials for 70s rock CDs, grout cleaners, and chia pets, ‘But wait, there’s more.’ . . . Health Savings Accounts appear, by my math, to be septuple-tax-advantaged account – with four distinct advantages over traditional 401(k) plans and IRAs.”

William G. (Bill) Stuart

Director of Strategy and Compliance

November 14, 2019

You’ve probably heard the phrase dozens of times: Health Savings Accounts are triple-tax-free.

Actually, they’re better than triple-tax-free. A lot better.

When people refer to Health Savings Accounts as triple-tax free, they’re looking at the three stages of funds flow in the accounts:

  1. Contributions are pre-tax or tax-deductible.
  2. Balances grow tax-deferred.
  3. Distributions for qualified expenses are tax-free.

In contrast, traditional and Roth 401(k) plans and Individual Retirement Arrangements are defined as double-tax free. Traditional account contributions are said to be tax-free, growth tax-deferred, and withdrawals included in taxable income. Roth account contributions are included in taxable income, balances grow-tax-deferred, and distributions are  tax-free.

But this analysis doesn’t highlight the entire tax difference between Health Savings Accounts and retirement accounts.

Payroll Taxes

Payroll taxes are applied to all contributions to retirement accounts, even traditional 401(k) plans and  IRA. Imagine you contribute $3,000 annually to your traditional 401(k) plan and increase your deposit by $100 each year for 30 years, the savings at a payroll tax of 7.65% (it drops to 1.45% on income above $139,800 in 2019, a figure that increases to $137,700 in 2020). If your income is below the ceiling, you pay $228.50 in payroll taxes this year and up to $451 in Year 30, when your contribution reaches $5,900.

That additional amount in your Health Savings Account, growing at 5% annually, creates a balance $22,000 greater at the end of 30 years. That’s an extra $22,000 to spend on qualified medical, dental, vision, and over-the-counter expenses, plus Medicare premiums, without any additional sacrifice in current consumption. The difference is the account into which you place the contribution. Period.

So, HSAs are now quadruple-tax-free:

  1. Contributions aren’t subject to federal and state taxes.
  2. Contributions aren’t subject to federal payroll taxes.
  3. Balances grow tax-deferred.
  4. Distributions for qualified expenses are tax-free.

To quote those commercials for 70s rock CDs, grout cleaners, and chia pets, “But wait, there’s more.”

IRMAA

IRMAA is an unwelcome guest at any party. The acronym stands for the Income-Related Monthly Adjustment Amount. That’s a mouthful. Here’s what it means: The standard Medicare Part B premium (which covers outpatient services) is $135.50 per month. The premium represents about 25% of the total cost of care. Taxpayers subsidize the other 75%, which is paid from general revenues. Medicare Part D (prescription-drug coverage plans) doesn’t have a set national premium because the plans are offered by private companies that compete on price. But the same ratio of about 25% participant to 75% taxpayer applies.

When enrollees report incomes above $87,000 for single filers and $174,000 for joint filers (2020 figures), the ratio changes. They’re responsible for 140% of the Part B or Part D premium – an acknowledgment that they need less of a taxpayer subsidy based on their income.

Now, you may believe that a retired couple earning $174,000 can afford to pay a higher percentage of the cost of their coverage. And you may be right. But not all Medicare enrollees are retired. Some are still working – perhaps trying to make up for the financial ravages that they experienced as a result of the Great Recession.

If they’re working for a small company (fewer than 20 employees), their employer’s insurer may require them to enroll in Medicare as a condition of remaining covered on the group plan. That’s because when these employees (and family members eligible to enroll in Medicare) receive care, the claim goes to Medicare for payment first. Many – not all, but many – insurers force Medicare-eligible working seniors to enroll in Medicare so that the private insurers are responsible for only a portion of the bill.

Required Minimum Distributions

No later than April 1 of the year after you turn age 70½, you must begin to take Required Minimum Distributions from your traditional 401(k) plan and IRA. The federal and your state government (if it imposes a tax on income) didn’t apply income taxes to your contributions or your investment gains. They’re patient, allowing you to build your balance and then applying taxes to not only your contributions, but your account growth. They’re patient, but sooner or later, these governments want to begin to reap that tax bonanza. So, they require you to begin to make withdrawals in the year that you turn age 70½.

The rate of withdrawal depends on the value of your accounts and your expected lifespan. The large the account value, the higher the annual RMDs. The longer your projected lifespan, the lower the RMDs.

Most people who are still working at age 70½ are probably doing so out of financial necessity. They probably began to receive Social Security benefits before their Full Retirement Age, so their monthly benefit is smaller than it otherwise would be. And that money alone (perhaps $1,000 monthly), combined with meager retirement savings, isn’t sufficient to allow them to stop working. They most likely have very small – if any – balances in a traditional 401(k) plan or an IRA, so they’re not affected by RMDs.

Other working seniors remain actively employed because the work stimulates them, they believe that they’re leveraging their experience in positive ways, and they can’t imagine a life without some level of intellectual engagement in the work force. This group includes doctors, lawyers, financial planners, retirement specialists, private school teachers, professors, and authors. Many make good incomes.

For them, RMDs create a tax problem. They don’t need distributions from their traditional 401(k) plans and IRAs to supplement their incomes. But they have to make the withdrawals anyway. Including those distributions in their taxable income may put them in a higher tax bracket (higher income tax liability) and increase their Medicare  Part B and Part D premiums (because of IRMAA).

Health Savings Account and Roth 401(k) plan and IRA withdrawals aren’t subject to RMDs. You can preserve your balances in these accounts until you need them. And if you’re required to make RMDs from other accounts, you’ll probably use those funds to pay your medical bills and continue to allow your Health Savings Account and Roth account balances to grow tax-free.

Provisional Income

Most Social Security recipients pay taxes on either 50% or 85% of their benefit. Those figures don’t represent the tax rate applied, but rather the percentage of the benefit that’s taxed. If they’re at 50% and have a $12,000 annual benefit, then $6,000 is included in their taxable income and 50% is tax-free.

The percentage of your Social Security benefit taxed depends on your provisional income. Provisional income includes a taxpayers Adjusted Gross Income (wages, distributions from retirement accounts, capital gains, interest income, dividends,, royalties, and rental income), income from tax-free instruments (such as tax-free municipal bonds), and half of the annual Social Security benefit.

Example: An individual withdraws $28,000 from her 401(k) plan, has $1,000 of income from a municipal bond, and receives $16,000 in Social Security benefits. Her total provisional income is $37,000 (remember, only half her Social Security income is counted). If she files an individual personal income tax return, the $37,000 in provisional income means that 85%, not 50% of her Social Security benefit is taxed. That’s a difference of $5,600 in taxable income ($13,600 vs. $8,000 if only 50% were taxed). At a 20% federal and state marginal income tax rate, she pays an additional $1,100 or so in taxes.

Distributions from a traditional 401(k) plan or IRA are included in provisional income. Withdrawals from a Health Savings Account or a Roth 401(k) plan or Roth IRA are not.

Multiplier Effect

You’ve probably grasped already the multiplier effect of these last three factors. RMDs from a traditional 401(k) plan or IRA increase taxable income, whether or not you need the money or not. Those distributions are included in provisional income, which may increase the percentage of your Social Security benefit that’s taxed. And although IRMAA isn’t technically a tax, higher income results in higher Medicare Part B and Part D premiums, which are an additional expense.

The Real Comparison

Let’s look at the tax financial advantages of a Health Savings Account versus a traditional 401(k) plan or IRA:

  1. No federal or state income taxes (except in California and New Jersey).
  2. No payroll taxes (net advantage over traditional accounts).
  3. Tax-deferred accumulation.
  4. Tax-free withdrawals for qualified expenses (net advantage over traditional accounts).
  5. No required minimum distributions (net advantage over traditional accounts).
  6. Not included in Provisional Income (net advantage over traditional accounts).
  7. Because of No. 5 and No. 6, Health Savings Accounts have less of an effect on IRMAA (net advantage over traditional accounts).

Health Savings Accounts appear, by my math, to be septuple-tax-advantaged account – with four distinct advantages over traditional 401(k) plans and IRAs, and two huge up-front advantages (Nos. 1, 2,) and one smaller one (Roth distributions are included in the IRMAA calculation) over their Roth counterparts.

But septuple doesn’t exactly roll off the tongue. So, use whatever term make sense to you. But don’t overlook the less well known tax advantages offered by Health Savings Accounts. They can have a decidedly positive and multiplicative effect on your financial future.

What We’re Reading

Is America’s cost of medical services received a function of higher utilization or higher insurance reimbursements? Check here for some perspectives.

The Wall Street Journal weighs in on a topic with which readers are familiar: Using your Health Savings Account as a retirement vehicle.

Has the nongroup insurance market stabilized, as many analysts believe, now that premiums are stable and declining in many markets? Not so fast, says Bob Leszewski. There are some disturbing trends. Read his always spot-on analysis here.

 

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