A friend of mine (let’s call him Jack) recently stated that since I’m constantly bloviating about Medicare surcharges, I should explain how he might be impacted when he retires.
“Ron, Help me understand how this ‘savings trap’ will affect me and give it to me straight,” he said solemnly.
“I wouldn’t have it any other way,” I responded.
First, I clarified what constitutes a surcharge: Medicare tacks additional fees on Medicare Parts B (doctor visits) and D (prescription drugs) based on retirement income, or, as Medicare, defines it—Modified Adjusted Gross Income (MAGI). This includes tax deferred savings, earned interest, capital gains, Social Security benefits, most pensions, and income generated from working in retirement.
Essentially, the more we earn, the more we will pay for basic Medicare coverage.
Back to Jack.
Jack is a 55-year-old single male, plans to retire at age 65, and currently has $600,000 in tax-deferred savings. He doesn’t have any taxable savings because other than his $19,000 annual 401k contribution, his income is earmarked for traditional fixed expenses, which includes his monthly alimony payment. Whatever is left over gets deposited in Atlantic City, Vegas, and local golf clubs.
Jack earns around $165,000 per year. He believes his compensation package will grow at around 2% annually to a little over $200,000 by the time he retires. After navigating through the Social Security website, Jack discovered he will be entitled to a monthly Social Security check of $2,400, which will be included in Medicare’s algorithm to calculate his surcharge.
I asked good ol’ Jack what he thought he would need, in addition to Social Security, to live comfortably in retirement. After some contemplation and calculation, he came to the following conclusion:
“I’ll need a hundred twenty five grand a year,” he said firmly.
“Do you want your income to increase with inflation?” I asked.
“Are you going to live in Massachusetts?”
“Yes, permanently. I’m going to be buried in Woodlawn Cemetery in Everett.” Have to give Jack credit for thinking ahead.
“What happens if you finally end up winning big in Atlantic City after you retire, but have a coronary while you are counting your winnings?”
“I’ll have enough cash to get shipped directly to Woodlawn,” he said, matter-of-factly.
“That’s reassuring,” I responded.
I sat back, ran some numbers off the HealthView surcharge application and said, “Here are the facts, Jack.”
Jack’s standard Medicare premiums, which cover hospitalization, doctor visits, and prescription drugs, will cost him $148,000, plus he will be responsible for an additional $141,000 in income-based surcharges.
Jack’s jaw dropped. “An extra hundred and forty grand? Are you kidding? How do I lower the surcharge?”
I projected the value of his $600,000 portfolio (excluding his future contributions) growing at 6% to $1,074,509. After a long debate, I convinced Jack to increase his annual 401k contributions from $19,000 to $23,000 a year. Consequently, Jack’s future contributions will add an additional $321,348 to his savings for a grand total of $1,395,857.
Then I told him that if he simply converts those future 401k contributions to a Roth 401k, 23% of his future savings would not be subject to MAGI, dropping his surcharge from $141,191 to $55,845. This, of course, would ultimately increase Jack’s discretionary gambling income by $4,267 annually, or, to put it another way, place an extra $85,346 into the coffers of Caesar’s Palace before his last trip to Woodlawn.
He felt better after that, and I’m certain the casino industry would strongly support Jack’s decision.
It’s important to realize that when Jack converts his future 401k contributions to a Roth, he will pay income taxes on those savings. However, in Jack’s case, it is much more appealing to face that expense today rather than pay both income taxes and $4,200 a year in Medicare surcharges when he no longer has the ability to generate an income. (Please note that the decision to pay taxes now instead of later—regardless of the present-value comparison—is personal, subjective, and unique to each individual.)
Bottom line: We can’t do anything about basic Medicare premiums, but we may be able to significantly reduce or eliminate Medicare surcharges, which could increase premiums by over 200%. Placing assets in products such as a Roth or Roth 401k is an excellent strategy to consider, and the long-term benefits can potentially increase disposable income by thousands of dollars.
Note that references to names and places have been changed to protect the identity of “Jack.”