The Medicare premium surtax jumped higher for many retirees in 2018, making planning for this
Stealth Tax more important now and in the future.
The Medicare premium surtax, or surcharge, is officially known by the acronym IRMAA (Income-Related Monthly Adjustment Amount). It was created by the Medicare Modernization Act of 2003, and was first imposed in 2007. But a 2015 law applied the surtax at lower income levels, beginning in 2018.
The idea behind the surtax is that higher-income beneficiaries should pay more for Medicare. This is part of the means-testing that I believe will expand as the financial conditions of Social Security
and Medicare deteriorate. Under the basic rules, Medicare Part B premiums are supposed to pay for 25% of expected costs of the program. But those with higher income levels pay a higher percentage of costs under IRMAA, with the highest income bracket paying 80% of expected costs through premiums and the surtax. Their premiums, plus IRMAA, can be more than 200% of the basic Part B premium. There’s a similar surtax for Part D prescription drug coverage.
As the accompanying table shows, the surtax begins for married couples filing jointly when modified adjusted gross income (MAGI) exceeds $170,000 and for individuals when MAGI exceeds $85,000. The top surtax is imposed on married couples when MAGI exceeds $320,000 and on singles above $160,000.
The basic Part B premium totals $1,608 in 2018, while the highest surtax adds $3,535.20 to the annual
bill. That’s only for Part B. A beneficiary with a Part D policy will have an additional surtax each month. The thresholds for the surtax are scheduled to be indexed for inflation after 2019. The surtax is paid as an addition to the premium. For both Parts B and D, you can have it withheld from Social Security benefits or Medicare can send you a bill each month.
IRMAA is imposed with a two-year lag. For example, your MAGI from 2018 will determine your IRMAA,
if any, for 2020. The Social Security Administration (SSA) receives your income tax data from the IRS in 2019 after your 2018 tax return is filed. In late 2019, the SSA sends you a letter telling
you what the surtax will be for 2020.
The first thing to note is that you can request a reduction in the surtax when there’s been a life-changing event that affects your income. If you just retired and therefore experienced a decline in income, you can file Form SSA-44 with the SSA and report the “work stoppage.” You also might need to do this for the second year of retirement. On the form, you estimate the MAGI for the current year and provide documentation of the life-changing event and the lower income.
Other life-changing events that qualify for a change in the surtax are marriage, divorce, annulment, death of a spouse, work reduction, loss of income-producing property, loss of pension and an employer settlement payment due to the employer’s bankruptcy. When you want to appeal the surtax and your life-changing event doesn’t fit into one of those categories, consider filing a Request for Reconsideration
on Form SSA-561-U2. You state the reasons you believe the MAGI from two years ago shouldn’t be used
to determine the current year’s Medicare premium surtax and wait for SSA to reply.
One-time increases in income don’t qualify for an adjustment. Your income might have increased because you converted part of a traditional IRA to a Roth IRA. Or there might have been a
sale of a home or other real estate or a large part of your investment portfolio. You might have received a significant bonus at work or some other large, one-time payment.
Your surtax won’t be adjusted based on any of these income increases. You’ll owe the higher surtax for one year. After that, when your regular income is used to compute future surtaxes, the surtax will decline or disappear.
That’s why it’s important to consider IRMAA and other Stealth Taxes (such as including Social Security benefits in gross income) as part of your regular income tax planning.
The first thing to keep in mind is that for anyone subject to the surtax, it is likely to be a small percentage, usually 1% to 2%, of total income. That means it probably isn’t worth making dramatic
moves to avoid or reduce the surtax. Also, someone who is well above the surtax threshold would have to reduce MAGI too much to avoid the surtax.
Even so, when additional income triggers the IRMAA or a higher IRMAA, the marginal tax rate on that
additional income can be very high. The income triggers its own income taxes plus the surtax. So, if you’re near the threshold for triggering the surtax or the next level of the surtax, it can be worth your while to take steps during the year to reduce or eliminate the surtax. Plus, a married couple’s surtax is
determined separately for each spouse. So, you could be paying double the numbers in the table.
Another reason to include the surtax in your tax planning is that the “hold harmless” rule for Social Security benefits doesn’t apply to the surtax. Under the hold harmless rule, when a beneficiary has Medicare Part B premiums deducted from Social Security benefits, any increase in Medicare premiums
can’t cause a net reduction in the Social Security benefits. The premiums can increase only as much as the benefits. The hold harmless rule doesn’t apply to the surtax. The surtax can eat away your Social Security benefits.
This and other Stealth Taxes are triggered by your MAGI. Your AGI is the number on the bottom of the first page of Form 1040. It is increased by your tax-exempt interest income, EE savings bond interest used for education expenses and excluded foreign earned income to arrive at MAGI.
MAGI isn’t affected by itemized deductions, such as mortgage interest, state and local taxes and charitable contributions. Instead, you reduce MAGI by reducing gross income and by increasing deductions from AGI. Frankly, few retirees qualify for the deductions from AGI, so you’re best bet
is to focus on reducing gross income.
Roth IRA distributions aren’t included in gross income. So, you can reduce future surtaxes by converting
some traditional IRAs or 401(k)s to a Roth IRA. The future distributions from the Roth IRA won’t be included in gross income and won’t affect the surtax. Keep in mind that the converted amount will be included in gross income for the year of the conversion, so it could trigger the surtax in two years. But after that, taking money from a Roth instead of a traditional IRA should save both income taxes
and the surtax.
It is best to do conversions a couple of years before you begin Medicare. But later conversions often can pay off when retirement is likely to last 20 years or longer. You can convert enough each year to keep you from drifting into the next higher income tax bracket and IRMAA threshold. Review our May 2018 issue for details about IRA conversions.
Tax-wise management of your investment portfolio also can reap savings by reducing MAGI. Investment
fundamentals should be the primary reason for every investment decision, but consider the tax angles as well.
Before selling an investment at a gain, consider the amount of sales already made during the year and where that leaves total MAGI. It might make sense to defer a sale until the next calendar year. Another good strategy is to look for investments that have paper losses. Sell those to offset any gains you are taking. You also might be able to designate which shares you are selling to minimize the capital gains for the year. See our March 2018 issue for details on designating the shares sold.
When choosing mutual funds, consider tax efficiency. Some mutual funds do a lot of trading each year, and that generates large distributions to shareholders. Other funds consider taxes in their strategies and minimize distributions each year. Tax efficiency can be found in a fund’s prospectus and also from services such as Morningstar.
You also should consider limiting distributions from traditional IRA and 401(k)s, annuities and similar tax-deferred vehicles. These distributions are included in gross income and taxed as ordinary income. Of course, some of these distributions are out of your control, such as required minimum distributions after age 70½. But there are times when you might need extra spending money and have a choice as
to the source of that money. Instead of taking it from a traditional IRA, for example, you might want to take it from a Roth account or by selling from a taxable account an asset with little or no gain.
The key is to know during the year what your MAGI is likely to be and make choices that will keep it within that range.