Feeling Fined by a Medicare Trap

Just when you think you’ve mastered Medicare and understand all the costs and co-pays—wham! Those with higher incomes get hit with a gently titled but harsh surcharge called the Medicare income-related monthly adjustment amount. Does this apply to you? Keep reading.

A curious calculation

The IRMAA isn’t part of your Medicare premium plan. Instead, it’s an additional amount paid directly to the Centers for Medicare and Medicaid Services. The payment is in addition to your regular monthly premium and is for those enrolled in Medicare Part B or Part D who qualify.

The IRMAA is based on your tax return from the two years before the year you’d actually owe it. To compute your annual income, the formula includes: your adjusted gross income plus any tax-exempt income, including interest payments from tax-free municipal bonds, plus deductions of student loan interest, any passive income loss, tuition and fees, taxable social security payments, and IRA contributions.

You read that right: Certain deductions are added back to calculate your annual income for the IRMAA eligibility. If it’s determined that you qualify for the IRMAA, the Social Security Administration will notify you. Read your mail!

It’s crucial to be aware of the future risks that may arise from the consequences of becoming an IRMAA victim. Shockingly, monthly premiums can triple regular premiums depending on your income tier.

[see table below]

In recent years, legislation was enacted that indexed the IRMAA tiers to the consumer price index for urban consumers. This is a good thing since retirees essentially must have a higher income than in previous years to qualify for the IRMAA. But still.

Don’t get trapped

There are some serious traps to watch out for while planning ahead. When designing a distribution plan from all your consolidated retirement savings and investment accounts, it’s critical to understand how the IRMAA and associated taxes can unintentionally impact your distributions—and more importantly, your financial future. Here are two to watch for:

• Required minimum distribution pitfall—With the exception of Roth IRAs, retirees are required to withdraw a percentage of their retirement accounts per the IRS required minimum distributions table. But there’s a catch when it comes to IRMAA.

At the end of the year, the higher the account balance, the higher the annual required withdrawal. You see, in the beginning years of RMDs, retirement accounts will typically grow more than the amount of the required distribution. However, as time passes, the percentage scheduled to be withdrawn increases per the distribution table. This means a hefty withdrawal could trigger the IRMAA and drastically affect your retirement for years to come.

• Bucket list blues—Upon retirement, most people tend to raid their accounts and begin spending and enjoying the fruits of their lifelong labor. Moreover, they start knocking out their bucket list while they’re still healthy, active, and able to travel.

Consequently, two years into all the bucket list fun, the IRMAA may kick in due to the withdrawals. Any withdrawals in your early years of retirement can lead to considerably higher monthly costs going forward. Might want to think about stretching out that bucket list.

Say no to IRMAA

With some smart planning, you have many employable tactics to avoid or minimize the IRMAA. But take good notes so you can run these ideas by your financial planner:

Avoid padding your pre-tax accounts—One of the most common ways to save for retirement is through pre-tax accounts, such as 401(k)s, 403(b)s, 457s, IRAs, etc. You should maximize allocations to your pre-tax savings accounts only to the extent of your employer match and nothing more. Any further amounts you save should be invested into an after-tax option.

Rethink liquidation—Another common way people are routinely taught to manage investments is to defer taxes as long as possible by withdrawing and using all your after-tax savings first while keeping pre-tax accounts intact. Not so fast. This rationale assumes that you’ll be in a lower tax bracket in the future because transitioning to retirement status tends to eliminate or immensely reduce your earned income.

That said, prolonging distributions from pre-tax accounts enables those accounts to continuously grow. And this explosive growth results in increased RMDs. And when these mandatory distributions begin, they add significant income that can creep into IRMAA territory.

To avoid this situation, consider different approaches to withdrawals, including a combination between pre-tax and after-tax accounts. Bottom line: Spend the necessary time on thoughtfully prioritizing your distributions for the best outcome.

Marked safe by charity—If you don’t necessarily need the income or have charitable aspirations, an RMD that risks activating the IRMAA can be used as a qualified charitable distribution. In other words, you could donate an RMD to a qualified 501(c)(3) organization.

Better yet, consider starting your own charitable organization to ensure your loving donation goes to a cause you support. This charitable RMD distribution isn’t a tax deduction, but it also won’t be considered taxable income either.

To Roth or not—A controversial strategy is converting all or part of any pre-tax accounts to a Roth IRA. Although converting to a Roth is an option, once funds have been taxed, there are many other investments available.

Nevertheless, if planned properly, any Roth conversions should be done in the tax years prior to age 70. Remember, IRMAA is decided according to tax returns from two years ago. Completing a Roth conversion well in advance will satisfy the taxes and diminish or slash future pre-tax countable income. This also weakens the likelihood of getting hit with the IRMAA.

Put it in reverse (a mortgage, that is)—If you’re like most retirees, your biggest asset is your personal residence. Many own their homes outright or are close to paying off their mortgage, holding massive equity.

One way to subsidize retirement without adding taxable income is to take out a reverse mortgage. Funds received from this source are tax-free and not factored into the IRMAA equation. There are intricate details involved in reverse mortgages that you’ll need to investigate, but you get the idea. For the right situation, this is a terrific option.

Put life insurance to work—Certain life insurance policies can distribute funds via built-up cash values providing that they don’t jeopardize the policy lapsing. These cash-value withdrawals are tax-free and not countable toward the IRMAA.

However, these withdrawals do offset the death benefit amount. Although this option is available for the appropriate insurance policy, it’s critical to have the life insurance policy thoroughly examined by a licensed and experienced insurance specialist with extensive expertise in distribution planning—not a financial advisor.

Monitor your mutual funds—In addition to auditing your pre-tax accounts, you’ll need to frequently monitor certain after-tax accounts due to the way capital gains and dividends are made. At year-end, most mutual funds held for more than a year may pay out sizable capital gains distributions or dividends that are added to taxable income. As a result, people unexpectedly earn more income that’s figured in for determining the IRMAA. These funds should be reallocated to an exchange-traded fund, which is more tax-efficient.

The beauty of capital losses—As with capital gains, the opposite holds true with losses. Any losses that can be generated or harvested to offset capital gains or scale down your taxable income would be helpful and applicable. I can’t emphasize enough the value of planning accordingly and well in advance to achieve this.

Challenging your penalty

If the SSA notifies you that the IRMAA has been triggered, you have appeal remedies to pursue using Form SSA-44. If the determination is incorrect, outdated, miscalculated, or there’s another qualifying reason to petition a reconsideration, you’re in luck, but with no guarantees.

Typical qualifying reasons requiring supportive evidence include:

• A decrease or loss in income over the past two years presents the possibility that the IRMAA could be rescinded or curtailed.
• You may provide a more recent tax return that reports a lower income than previously reported.
• A “life-changing event” has substantially affected your income. SSA clearly defines life-changing events as death, marriage, divorce or annulment, or retirement or that of a spouse.
• Loss of a pension or a one-time settlement payment from an employer due to going out of business or bankruptcy.
• An involuntary loss of income-producing property due to a natural disaster, fraud, or other event beyond your control could be considered.
• You may have filed an amendment to your tax return that changed the taxable income amount and lowered it below the annual income tier that would repeal the IRMAA; or the amendment dropped you down an income tier, which would lessen the monthly premium amount.
• You’ve experienced a reduction in work hours due to health reasons or have assumed caretaker responsibilities.

It’s important to know that if the IRMAA was the result of a lone event, the success of an appeal or redetermination is highly unlikely. That’s why planning and timing is so important.

Let’s say that in the strategy of converting a pre-tax account to a Roth IRA, the conversion wasn’t fully completed prior to the two-year lookback. In that scenario, the IRMAA would be validated without an appeal or reconsideration to put forward.

Likewise, if there was a huge distribution from your pre-tax account that reached the qualifying annual income tiers, the IRMAA could be there to stay. Ouch!

Another one-off event that’s overlooked in retirement planning is a property sale. Check this out: If a home sale captures handsome profits and is subject to capital gains taxes, this could easily spark the IRMAA. So if you’re planning on downsizing or selling your home closer to retirement, these are all things to consider and include in your retirement planning strategy.

See what a disaster this could be? The focus is to sidestep the IRMAA altogether.

Once your appeal is received by SSA, keep in mind that it’s under no designated timeline or deadline to respond to you. If your appeal is denied, you can appeal to the Office of Medicare Hearings and Appeals within 60 days of the date of the reconsideration denial letter. If you have new evidence for the OMHA appeal, you must submit it within 10 days from the date of the appeal. If OMHA denies the appeal, you can appeal to the council within 60 days of the denial letter. Lastly, if the council denies the appeal, you can escalate your appeal to your local federal district court within 60 days of the council’s denial letter.

Yes, it’s an arduous process. But considering the exorbitant costs of the IRMAA, this is a battle definitely worth fighting. Draw your sword. If you don’t, you could be feeling fined every month for the rest of your life.