Stretch Your Retirement Dollars with the Right Account

Two elderly people sitting on stools overlooking a lake with trees in the background

“Each couple sacrificed the same amount of immediate consumption during their working years. Each earned the same return. Each incurred the same level of medical expenses in retirement. Yet the Health Savings Account owners were able to stretch their money an additional six or eight years because of the more favorable tax treatment of their accounts.”

William G. (Bill) Stuart

Director of Strategy and Compliance

July 9, 2020

Many, many of my contemporaries are in for a rude awakening.

I feel fortunate that I’m not among them on this issue (although God help me on a lot of other topics). I don’t know whether I’m aware because I’ve acquired specialized knowledge or I’m experiencing the Baader-Meinhof phenomenon. The reason doesn’t really matter. But the issue does.

Many of my friends and I are within a decade of retirement. Most of us are still passionate and productive at work. But the clock keeps ticking (good thing!), and at some point we’ll be transitioning toward some form of retirement that is likely to include more time to pursue personal interests and volunteer activity, perhaps some paid work, and a shift from employer-sponsored medical coverage to Medicare.

It’s the last point that many of my contemporaries don’t begin to understand. And that lack of understanding will cost them a lot of money.

But this column isn’t just for this age band. As with general retirement savings, people who begin to plan early for retiree medical costs will have a huge financial advantage over those who don’t. And that advantage will translate into more freedom to pursue their interests, activities, and passions during their retirement years.

Medicare Part A

Medicare is nothing like today’s coverage. That’s because it was created in 1965 to mirror the coverage of that era, and Congress has never changed the basic structure of the program. Back in 1965, the dominant insurers were Blue Cross and Blue Shield. The key word in that sentence is were, not was, because the two were separate entities covering different services.

Medicare Part A (like the old Blue Cross) covers inpatient services, plus home health and hospice. Patients pay a $1,408 deductible for each period of hospital care, then receive full coverage for 60 days annually, then an additional 30 days at a copay of $352 per day (more than $10,000 if they use all 30). After that, they have another 60 lifetime days (at a $704 daily copay, or more than $42,000 total) that they can use at any time after they exhaust their 90-day annual allotment.

In contrast, employer-sponsored plan reimburses an unlimited number of days of inpatient care. Those services may be subject to a deductible, copays, or coinsurance, but in most cases a patient’s out-of-pocket financial responsibility for all services (inpatient and outpatient) is capped at $8,150 under federal law.

Medicare Part B (like the old Blue Shield) reimburses outpatient care – everything from doctor visits and lab work to high-tech imaging, physical therapy, and outpatient cancer treatment, and dialysis. It has an annual deductible of $198, then 20% coinsurance applied to all costs beyond the deductible. There is no annual limit. So, cancer outpatient treatment totaling $150,000 would leave a patient with a bill of $30,158.40. Most enrollees purchase a Medicare supplement plan for $200 to $300 per month that covers Part B coinsurance and some other Medicare expenses.

In contrast, employer-sponsored coverage typically applies these (and inpatient) services to a higher deductible and perhaps coinsurance. But a patient’s financial responsibility for inpatient and outpatient services combined is capped at $8,150 in 2020.

Traditional Medicare doesn’t cover outpatient prescription drugs (although Part D – beyond the scope of this discussion – is available to reimburse a portion of these costs, with patient cost-sharing). And it doesn’t cover most dental or optical services either. And Medicare hasn’t negotiated special discounts with gyms, optical shops, and other health-related services.

The Premium Misunderstanding

My contemporaries are shocked when they learn more about their potential financial responsibility when they receive care. They’re comforted by their understanding that they’re prepaying their Medicare premiums through their payroll taxes, so that at least they don’t have that burden when they enroll in their retiree medical plan. Except they’re wrong.

Yes, all workers pay federal payroll taxes equal to 15.3% of taxable earnings, paid half by employees and half by employers. That tax is reduced to 2.9% on all taxable income above $137,700, which means that the full amount applies to most workers. Of that 15.3% total, 12.4% funds Social Security – though not sufficiently to pay full benefits after 2034 (see page 11 of this report).

The remaining 2.9% pays Medicare premiums – but only for Part A. Expenditures exceed income this year (and that’s before the political response to COVID-19) temporarily removed about 40 million Americans from the company payrolls on which the tax is applied). The difference is covered by the trust fund, an accounting term reflecting the surplus of revenue over expenditures since the program launched 55 years ago. That surplus is projected to be gone (in pre-COVID-19 calculations) by 2026, at which time some combination of higher payroll taxes, premiums assessed for recipients, reduced payments to hospitals, transfers from general tax revenue, or borrowing will have to cover the deficit.

Part B enrollees pay a monthly premium that’s heavily subsidized by general revenues. The base premium is $144.60 (about one quarter of the cost of claims, as general revenues cover the balance). That’s $1,735 per enrollee, or nearly $3,750 per couple.

Higher-income retirees pay higher premiums as the taxpayer subsidies are reduced. Premiums are assessed in income two years prior. So, a new retiree will pay the Part B premium based not on retirement income, but rather taxable income during the final two years of work. For a couple earning $220,000 in the two years prior to retirement, the monthly Part B premium is $289.20 each, or $578.40 monthly ($6,941 annually).

The Cost of Retiree Medical Care

How much will the average couple need to cover retiree medical premiums, out-of-pocket costs, and services not covered by Medicare? Fidelity projects the figure for a couple retiring at age 65 in 2019 at $285,000 in today’s dollars.

 Kaiser Family Foundation estimated in 2019 that the average Medicare recipient spent $5,460 between services ($3,166) and premiums ($2,294) in 2016. Add a 3% annual inflation rate and the figure is $5,934 per person (or $11,867 per couple). Project that figure forward for 20 years of retirement and the couple pays just under $320,000.

The Employee Benefit Research Institute estimates that a couple needs $301,000 in savings to have a 90% chance of covering premiums and out-of-pocket costs.

These three different approaches validate each other in concluding that a couple living 20 years beyond age 65 will need roughly $300,000 to $350,000 in inflation-adjusted dollars to pay for their medical care in retirement.

How to Pay for Retiree Medical Care

Most retirees live on some combination of Social Security benefits, pension payouts, and personal savings accumulated largely through tax-advantaged accounts. We’ll focus on the personal savings through tax-advantaged accounts.

Imagine three couples read this column when they’re each age 35. They realize that they need to begin to save for retiree medical expenses. So, they each defer $3,000 of spending annually for 30 years and place that money in a tax-advantaged account to pay their retiree medical expenses. They earn 5% annually on their money for 30 years. Then, they incur $12,000 of premium and out-of-pocket expenses during their first year of retirement, a figure that increases by 3% annually due to medical inflation.

This model is far from perfect, but it’s simple. Most people incur lower out-of-pocket costs when they first retire, then higher costs as they age. And more people are working full-time past age 65, replacing some Medicare years with employer-sponsored (and -subsidized) coverage. Investment returns vary depending on the performance of stock and bond markets. Taxes vary over time. But let’s keep things simple.

The Andersons put their funds in a traditional 401(k) plan. Their contributions aren’t subject to federal or state income taxes, but they incur payroll taxes, so their $3,000 contribution is reduced to $2,770.50 annually. They accumulate $193,000 after 30 years, then retire. Their withdrawals are included in their taxable income, so they need to withdraw nearly $14,500 in their first year of retirement to pay $12,000 of expenses and taxes (17% federal and state) on the withdrawal. They exhaust their balance early in their 17th year of retirement (age 82).

The Baxters place their funds in a Roth IRA. Contributions are taxable, so their deposits are reduced to $2,100 annually. They build their balance to more than $146,000 after 30 years. Their withdrawals are tax-free. They run out of money midway through their 15th year of retirement (age 80).

The Currans are enrolled in HSA-qualified coverage. They place their $3,000 in a Health Savings Account, avoiding taxes on contributions and withdrawals for qualified expenses. Fortunately, all the expenses listed in this article, except for Medicare supplement premiums, are qualified expenses. Their balance grows to more than $209,000 after 30 years. They exhaust their balance about four months into their 23rd year of retirement (age 88).

The Power of Health Savings Accounts

Seventeen years. Fifteen  years. Twenty-three years. What’s the difference in the three scenarios? Nothing except the tax treatment of contributions and distributions.

Each couple sacrificed the same amount of immediate consumption during their working years. Each earned the same return. Each incurred the same level of medical expenses in retirement. Yet the Health Savings Account owners were able to stretch their money an additional six or eight years because of the more favorable tax treatment of their accounts.

During those six or eight years, inflation pushed the Currans’ annual expenses to more than $20,000 annually. Thus, they’re depleting their other sources of income by $20,000 less to cover medical expenses. That’s $20,000 less to travel, help fund their grandchildren’s educations or first homes, or leave a legacy in another form.

My contemporaries don’t have enough time to prepare themselves fully for $300,000 in retiree medical expenses. Maybe they’ll be “lucky” and die young. More than likely, they’ll pay these expenses with taxable withdrawals from a traditional 401(k) plan or IRA, or from a taxable stream of income (like their Social Security payments).

They would have been better off if they’d learned about the benefits of Health Savings Accounts around 2004, when the accounts were first offered. And certainly by 2007, when some major changes to the rules allowed account owners to increase their annual contributions dramatically.

But missing the boat more than a decade ago doesn’t mean that they can’t catch the current ferry. After all, the best time to plant a tree for shade was 20 years ago. The second best time is today. And so it is with Health Savings Accounts.

What We’re Reading

The American Society of Pension Professionals and Actuaries buttresses my case above with its own analysis of Health Savings Accounts as retirement opportunities.

High Health Savings Account balances are an important piece of an estate. And understanding the tax implications of passing your balance to your heirs is critical to your legacy. Learn some of the important considerations here.


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