The rules governing Medicare’s income-based surcharges are changing again beginning in 2020—once again highlighting the importance of planning to minimize taxable income in the years prior to Medicare enrollment in order to avoid paying higher Medicare premiums for life.
Beginning in 2020, the income thresholds used to determine liability for the surcharges will be indexed to the consumer price index to account for inflation. However, beginning last year, the income thresholds were modified so that moderate-income taxpayers who once landed in the third-tier (on a scale of one to six) now pay higher surcharges at the fifth-tier rates. Because of these changes, it is especially important for moderate income clients to pay close attention to their taxable income levels—with proper advance planning, these clients may be able to save dramatically on Medicare premiums.
Medicare’s Income-Based Surcharges
Medicare income-based surcharges are determined based on a sliding scale that uses the Medicare recipient’s modified adjusted gross income (MAGI) to determine liability for Medicare premium costs. Six tiers of income levels currently exist, and the amount of an individual’s income-based surcharge is determined based upon the tier in which his or her income falls. Beginning in 2018, the rules changed so that more moderate-income clients now find themselves in the tiers that impose the highest surcharges.
Under the rules, single clients who fall into the “first tier” with MAGI under $85,000 in 2019 ($170,000 for joint returns) are not subject to the income-based surcharges and pay $135.50 for their monthly Medicare Part B premium. Conversely, single clients with MAGI of between $160,001 and $500,000 fall into the second-highest (“fifth tier”) income bracket, and clients with MAGI that exceeds $500,000 (single) or $750,000 (joint returns) pay the highest surcharges in the sixth tier.
Prior to the changes enacted last year, taxpayers with MAGI of up to $160,000 ($320,000 for joint returns) landed in the third tier. Importantly, the income-based surcharges result in Medicare premium costs that can reach $460.50 per person every month
Beginning in 2020, however, those income brackets will be indexed for inflation for the first time in nearly a decade, meaning that the first-tier income level will increase to $86,000. The fifth-tier income bracket will include taxpayers with MAGI between $163,001 and $500,000 for 2020. However, clients in the highest income brackets will not benefit from indexing until 2028, so these taxpayers will remain in the highest tier despite indexing at lower levels.
Planning to Minimize the Surcharge
These surcharges make taxable income levels in the years prior to Medicare enrollment especially important—Medicare bases the client’s premium costs on that client’s MAGI two years prior to enrollment (known as the “lookback” period). Clients should, of course, take advantage of tax-preferred retirement accounts to reduce AGI and avoid these surcharges—contributing to a 401(k) plan can reduce AGI by at least $19,000 in 2019 (clients age 50 and older can contribute an additional $6,000 in pre-tax funds to these accounts).
Contributions to health savings accounts (HSAs) can also reduce AGI by up to $7,000 per year for a client with family coverage in 2019 and, after reaching age 65, the client can withdraw the funds for any purpose without penalty, subject to ordinary income tax rates. Clients who have reached age 70½ can reduce AGI by up to $100,000 per year by using their IRA required minimum distribution (RMD) to contribute to charity in a qualified charitable distribution.
For other clients, it may actually be better to increase AGI at some point before retirement with the goal of reducing taxable income (and taking advantage of the benefits a lower income can provide) later in life. This would subject the client to a larger tax bill in a short period of time in order to plan for tax-free income (and a reduced AGI) at least two years prior to Medicare enrollment. Frequently, this can be accomplished by converting retirement funds to a Roth account. Other clients may choose to sell off assets in a single year, pay taxes on the gain and contribute the profits to a Roth that can be accessed tax-free in the future.
Becoming subject to Medicare’s income-based surcharges can increase Medicare premium costs substantially. The 2019 tax year is used in determining whether surcharges will apply for clients who enroll in 2021, so it’s never too early to start planning to avoid Medicare’s potentially lifelong surcharges.