6 Ways to Help Clients Avoid Medicare's IRMAA Surcharges in Retirement

Retirees are declaring bankruptcy at far greater rates today than in years past. In fact, the bankruptcy rate for those 65 and older has increased by more than 200% from 1991 to today.

One major reason for this rise in bankruptcies is the soaring cost of medical care. Case in point: A 65-year-old couple retiring in 2021 will need a staggering $300,000 to cover their health care and medical expenses throughout retirement, according to Fidelity Investments' latest annual retiree health care cost estimate.

Financial advisors need to be aware of the long-term risks that may arise from these health care costs and should be prepared with solutions. In addition, they need to understand how Medicare's income-related monthly adjustment amount (IRMAA) can affect retirees' financial security.

IRMAA is a means testing program that was established in 2003 to help extend Medicare's solvency by increasing the premium that some Medicare beneficiaries pay based on their income. Since 2003, IRMAA's income brackets, calculated from a retiree's prior two years' modified adjusted gross income (MAGI), determine the surcharges that higher earners pay.

Individuals who reported MAGIs under $85,000 and married couples filing jointly who reported MAGIs under $170,000 on their 2019 returns are paying the current Medicare part B premium of $148.50 a month.

Individuals and couples reporting higher MAGIs in 2019 are currently experiencing an IRMAA surcharge on both Part B and Part D. These surcharges are assessed across five levels. At their worst, if a single filer's MAGI exceeds $500,000 and a couple's MAGI exceeds $750,000, the surcharge would be more than double the basic Medicare premium. Someone paying the premium plus the surcharge could be paying more than three times the basic Medicare premium compared to those not impacted by IRMAA.

Indexed to CPI-U

Fortunately, legislation was passed in 2020 resulting in IRMAA brackets now being indexed to the Consumer Price Index for Urban Consumers (CPI-U). This means that a retiree will need to have a higher MAGI than in previous years to be subject to the surcharges. The MAGIs for 2021 are $88,000 for single filers and $176,000 for joint filers.

But there are still a couple of subtle yet significant traps that advisors can help their clients avoid when setting up retirement savings and retirement income distribution plans. These can be triggered by:

Overspending at the start of retirement. Many retirees tend to spend more at the beginning of retirement when they are healthy, active and checking off their bucket list items. Because IRMAA surcharges are calculated based on a two-year "lookback" period for MAGI, clients can be hit with IRMAA surcharges even if their income drops significantly in mid-retirement.
Onset of required minimum distributions. Americans are required to make withdrawals from most retirement plans — except Roth IRAs — when they reach the age of 72. The amount of the withdrawal is based on the client's remaining life expectancy as determined by the IRS' unified table and the Dec. 31 total qualified account value.

The larger the year-end account value, the higher the annual RMD. In the early years of RMDs, the investment balance can grow faster than the percentage the RMD calculation requires, and consequently as the RMD factor increases due to aging, it is applied to a larger investment value. This could catapult clients into a higher IRMAA bracket, resulting in higher premium surcharges.

6 Strategies for Avoiding IRMAA Issues

1. Don't assume nonqualified accounts should be used first in a liquidation order strategy.

A popular pre-retirement accumulation strategy is to defer taxes for as long as possible. The assumption is that many people will be in a lower tax bracket in retirement than they were while still working. Unfortunately, continuing to defer taxes on distributions from qualified accounts (i.e., 401(k)s, IRAs, 403(b)s, 457s, etc.) after retirement by taking income from nonqualified accounts first, could result in the qualified account balance(s) growing so large that when the retiree reaches age 72 when they are required to start taking distributions, the RMD not only forces more income than the retiree wants or needs, but also moves them into an IRMAA surcharge bracket on their Medicare premiums.

This could result in over $100,000 of future IRMAA charges that could be avoided with proper planning. There is no "rule of thumb" for liquidation order that works best for everyone. IRMAA avoidance is one factor that influences liquidation order, but there are others that should be considered.

2. Consider Roth conversions.

A Roth conversion, in which all or part of the balance of an existing traditional IRA is converted to a Roth IRA, is another way to avoid getting bumped into higher IRMAA brackets.

This may result in paying more taxes and IRMAA surcharges for a short period now but can avoid ongoing IRMAA surcharges later if the client is forced to take more income due to higher RMDs. Keep in mind that Medicare determines your IRMAA bracket by looking at your tax return from two years prior to RMDs. If at all possible, complete your Roth conversions by age 69.

3. Use RMDs for charitable contributions.

If a client is at risk of higher IRMAA surcharges due to RMDs and they don't need that income, advisors may want to suggest a qualified charitable distribution and have the RMD donated to their favorite charity. The distributions will not be considered taxable income, thus avoiding an increase in MAGI and a potentially higher IRMAA bracket.

4. Don't over-save in pretax accounts.

There has always been a strong emphasis on diversifying investments through proper asset allocation while accumulating, but not enough emphasis is placed on also diversifying your tax strategies.

With a change in tax laws, which Congress has historically done about every 10 years, today's best tax strategy could become tomorrow's worst. Advisors may want to suggest their clients avoid placing all their retirement contributions into 401(k) plans and IRAs.

Employees should, of course, save enough in a 401(k) to maximize any employer match, but contributions beyond that matching amount should be redirected to a Roth option in their 401(k), if available; an individual Roth IRA account or another "after tax" savings account.

5. Reverse mortgages.

For many retirees, the equity in their personal residence represents a significant portion of their net worth. This untapped equity can be accessed "tax free" with a variety of reverse mortgages.

This not only helps avoid the IRMAA surcharge trap but can avoid what is popularly referred to as "bracket creep." If you can avoid moving into higher marginal tax brackets and avoid IRMAA surcharges through the use of a reverse mortgage, it might be worth considering. However, reverse mortgages are complex instruments that must be carefully researched before implementing.

6. Life insurance.

Cash values in certain life insurance policies also can be distributed as tax-free income and help clients avoid IRMAA surcharges. Again, advisors must carefully examine their clients' life insurance policies, as not all qualify. With some, there is a risk of the policy lapsing, which would create a very unfavorable tax consequence called "phantom income."

There are other situations with qualifying policies that also must be avoided. Clients would therefore do best to work with an advisor who has life insurance qualifications and licenses, such as a Chartered Life Underwriter (CLU) or a Chartered Financial Consultant (ChFC), both of which indicate specific expertise in the structure and use of insurance products.

There is a process available to clients if they feel an IRMAA surcharge is incorrect for one of several qualifying reasons and wish to appeal by requesting a reconsideration of the initial determination from the Social Security Administration. But there is no guarantee that the appeal will be successful, so the best course of action is to avoid the IRMAA surcharge in the first place, if possible.

Advisors should take a holistic view of their clients' investments and recognize that saving for retirement is significantly different from spending in retirement. This should include developing a written retirement income plan that illustrates exactly what income the client wants each year of retirement and what types of accounts will provide that income.

The advisor and client can then see if that income will trigger an IRMAA surcharge and can use any or a combination of the strategies cited to avoid these surcharges. For example, a time segmentation planning model can help to ensure that clients are prepared to allocate their retirement funds appropriately over time to ensure adequate, inflation-proofed income without triggering higher Medicare premiums. As always, the goal is to provide clients with the peace of mind they seek from their financial advisor.

Phil Lubinski, CFP, is co-founder and retirement income specialist at IncomeConductor. He's spent over 30 years as a financial advisor, serving almost exclusively retirement income planning clients, and has trained thousands of advisors from around the country on his time-segmented retirement income strategy. Phil has co-developed several fintech systems designed to help advisors create income plans for their clients.