Clients who have already retired rely upon the steady, predictable receipt of a monthly Social Security benefit—and a reduction in the amount of that benefit check can cause major planning issues.  Unfortunately, the situation is not uncommon, as unplanned increases in income—whether because of a property sale or extra IRA distribution—can easily cause clients to be pushed into the realm of the Medicare income-based surcharge.  What most clients don’t realize is that a spike in income during one year can cause a chain reaction that will eventually lead to a reduction in that stable monthly Social Security check—unless the client plans in advance to avoid this uncomfortable surprise. 

Medicare’s Income-Based Surcharges

Medicare Part B premiums and income-based surcharges are deducted directly from clients’ Social Security checks, meaning that without proper planning, the income that even your middle class clients have been counting on for retirement may be diminished in the years following a higher-income year.

Medicare income-based surcharges essentially increase the cost of premiums for Medicare Parts B and D for those clients who have MAGI that exceeds $85,000 for individuals or $170,000 for married clients filing jointly. The surcharge is imposed based on a sliding scale, with the highest surcharge imposed upon single clients with MAGI exceeding $214,400 and couples with MAGI that exceeds $428,000.  While the base Medicare Part B premium amount is $104.90, taxpayers with modified adjusted gross income (MAGI) in the highest Medicare bracket will pay more than three times that amount—or $335.70 each month per person.

While these income levels may seem relatively high for most retirees, they have not been adjusted for inflation since 2007 and have begun to impact a growing number of Medicare applicants, especially those who have not yet retired when they qualify for Medicare at age 65. Importantly, Medicare uses a two-year look-back period that is often overlooked by both clients and advisors.

The two-year look-back period essentially means that 2015 Medicare premium costs are based on 2013 income levels. Because MAGI includes most types of traditional income—including wages, Social Security, IRA and 401(k) distributions, dividends, earned interest, and capital gains—the risk that a client will be liable for Medicare surcharges, at least in the early years of retirement, is very high.

Avoiding the Surcharge

Unfortunately, once the client’s income has crossed the threshold so that he or she is subject to the Medicare income-based surcharge, the client can only qualify for a premium adjustment if a certain qualifying life event has taken place.  These events include marriage, divorce, death of a spouse, retirement and losses caused by natural disasters, among others. 

If any of these events have occurred, the client can file a Form SSA-44 with the Social Security Administration to request a premium reduction.  This form will request evidence of the life changing event that the client is relying upon, or other evidence of the client’s MAGI if he or she believes the income-based surcharge was imposed in error.

Clients can also plan in advance in order to avoid the surcharges.  Income received on a tax-free basis in retirement is not included in calculating a client’s MAGI. This means that income drawn from after-tax retirement savings vehicles, such as Roth IRAs or Roth 401(k)s, is excluded from a client’s MAGI. Similarly, income from a health savings account, which also allows tax-free savings to accumulate over the years, is excluded.  Income from tax-preferred planning vehicles (such as permanent life insurance or annuity products) similarly will not increase a client’s MAGI

Conclusion

Because of the difficulty in obtaining a premium adjustment once a client has MAGI in excess of the threshold levels, proper planning is critical to helping clients avoid the painful surprise of learning that their monthly Social Security benefit for the year will be reduced.

Originally published on Tax Facts Online,the premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.   

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