Editor's note: This is part three of a seven-part series. It dives more deeply into how high income from required minimum distributions (RMDs) can cost retirees hundreds of thousands of dollars in Medicare surcharges. If you missed the introductory article, you may find it helpful to start here.
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No one wants to pay hundreds of thousands of dollars or even over $1 million more than they have to for Medicare in retirement. But due to means testing, that's what could happen if you're a diligent saver who stashes every penny you can into your 401(k) or other pre-tax retirement savings account.
This article is a summary of a ground-breaking white paper I published in 2019, in case you want to dive deeper into the history and mechanics of Medicare means testing. All general data cited in today's article about Medicare can be found in the 2019 paper.
Traditional Medicare services consist of Part A (hospital care), Part B (doctor) and Part D (prescription drug) coverage. Many retirees mistakenly think Medicare is free because they've been paying Medicare taxes into the system for their working lives. 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% annually from 1970 to 2019, a shockingly high rate over an extended period. That's similar to the inflation rates we've been experiencing in 2002, but instead 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 equal to 25% of projected per capita costs, meaning the government is covering the other 75% for most (but not all) retirees. Despite the subsidies, significant cost increases have been passed on to retirees. Base Medicare Part B premiums rose 7.5% annually from 1966 to 2019 (from $3.00 a month to $135.50 a month). In comparison, the core annual inflation rate (at least through 2019) has been about 2.3%.
Medicare itself faces solvency questions even more severe than Social Security. The only way to improve the solvency of Medicare is to raise taxes, reduce benefits or incur larger deficits. That's not a political statement. It's math. And it's why, as of 2019, the Medicare trustees expected Medicare Part B premiums on average to rise 5.17% annually from 2020 to 2027.
Following 2003 legislation, the government started reducing the subsidy for high-income individuals, forcing them to pay higher premiums on Part B and Part D beginning in 2007. These higher premiums are known as Income-Related Monthly Adjustment Amount (IRMAA) surcharges or "means testing." I think of them as avoidable taxes, provided you do some long-term planning.
The chart below shows Part B and Part D premiums for 2022 (the Part D premiums are for a plan in Austin, Texas). Premiums are tied to modified adjusted gross income from two years prior, so 2022 rates use income from 2020. Premiums for the highest earners compared to the lowest earners are 3.4 times higher for Part B and 4.4 times higher for Part D.
Source: Centers for Medicare & Medicaid Services
At higher income levels the government reduces the per capita federal subsidy, causing retirees to bear a greater portion of the cost. From 2007 to 2019, the base premium increased by 3.1% annually, while premiums for means testing tiers increased from 5.0% to 8.6% annually.
The concept of means testing shouldn't be a big surprise because the most politically acceptable way to improve Medicare's finances is to make wealthier people pay more. All the signs suggest means testing will become more severe over time.
From 2009 through 2019, income brackets were not indexed for inflation, and in some years, the government even reduced income brackets. So over time, more people have been getting snared by means testing. Starting in 2020, income brackets were indexed for inflation, which was good news for retirees, but the government could easily halt inflation adjustments to help balance the Medicare books.
Recall from last week's article on RMDs, the case study of a 40-year-old couple who saved $500,000 combined in pre-tax retirement accounts and continue to max out pre-tax contributions until retirement at age 65.
The couple's tax-deferred retirement accounts grow to $11.9 million by age 72, when they take their first taxable RMD of $435,820. The RMD snowballs, growing to $1.3 million of taxable income at age 90.
In the table above, the couple is projected to be in means testing tier three from age 74-76 and tier four from age 77 to 90. Their total "base" Medicare Part B and Part D premiums from age 65 to age 90 are projected at $856,526 (in future dollars, with each income bracket inflated using the historical Medicare inflation rate of 5.17% as of 2019). However, the couple will face an additional $1.5 million in Medicare means testing surcharges through age 90.
So far, this series has looked at how tax-deferred saving can create problems with RMD income and Medicare means testing surcharges. My next article will focus on problem No. 3: inherited tax liabilities.