Tax Moves Now Can Avoid Higher Medicare Premiums in Two Years

Paying close attention to your tax situation today can help avoid paying much higher Medicare premiums in two years.

This Stealth Tax catches more and more Americans age 65 and over by surprise every year. The Medicare premium surtax was created to add means-testing to Medicare, charging higher-income beneficiaries larger premiums for Parts B and D of the program.

The basic Part B premium is supposed to pay for 25% of expected costs for the program for the year. Under the premium surtax, higher-income beneficiaries pay a higher percentage of the estimated program costs.

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. Both the amount of the surtax and the income brackets at which different levels of the surtax kick in are indexed for inflation each year.

In addition to IRMAA for Part B premiums, there’s a premium surtax for Part D prescription drug plans.

The table shows how the premiums vary in 2021 at different levels of modified adjusted gross income (MAGI), which I will define later.The basic Part B premium totals $1,782 in 2021 ($148.50 per month), while the highest surtax makes the annual premium $6,048 ($504.90 per month) or about 340% of the annual bill.

A beneficiary with a Part D policy will pay an additional surtax each month on that policy. Those numbers are per beneficiary. A married couple will pay twice those amounts.

You can have premiums for both Parts B and D withheld from your Social Security benefits. If you elect that, the IRMAA amounts automatically will be withheld. Otherwise, you’ll be billed monthly for the Part B premiums by Medicare and the insurance company will bill you for Part D premiums.

One of the tricks to IRMAA is that it is imposed with a two-year lag. For example, your MAGI from your 2019 income tax return will determine your IRMAA, if any, for 2021. The Social Security Administration (SSA) received your 2019 income tax data from the IRS in 2020 after your 2019 tax return was filed.

In late 2020, the SSA sent each Medicare beneficiary a letter stating what the surtax will be in 2021.That means when you sign up for Medicare for the first time at age 65, your modified adjusted gross income from age 63 is used to calculate your premium surtax for the first year.

Fortunately, you can request a reduction or elimination of the surtax when a life-changing event made this year’s income lower than the income two years ago. 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.

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 do not qualify for an adjustment.

Your MAGI two years earlier 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 for any of these events. You’ll owe the higher surtax this year for the jump in income two years ago. If your income declines to normal levels in the following years, the surtax should decline or disappear.

IRMAA and other Stealth Taxes (such as including Social Security benefits in gross income) are why you should consider more than regular income taxes in your planning in your 60s and beyond. You need to focus on MAGI and whether you can reduce it to avoid or limit the premium surtax, taxes on Social Security benefits and other Stealth Taxes. The surtax initially appears to be a small percentage, usually 1% to 2%, of MAGI. The top IRMAA in 2021 is $6,058.80 for the year.

That’s imposed only for MAGI of $500,000 or higher. The surtax is less than 2% of MAGI. The percentage is a little higher when the Part D surtax is imposed.So, you don’t want to take drastic moves to avoid IRMAA, and if you’re well above the income threshold you won’t be able to do much to reduce or eliminate IRMAA.

But when the surtax is added to income taxes and any other Stealth Taxes, your marginal tax rate on each additional dollar of income can be quite high. Tax planning moves that reduce both income taxes and Stealth Taxes are more valuable.

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, in a married couple the surtax is deter-mined separately for each spouse. So, you could be paying double the numbers in the table, and that makes tax planning more valuable.

Also, keep in mind that the “hold harmless” rule for Social Security benefits doesn’t apply to the surtax. Under the hold harmless rule, when a bene-ficiary has Medicare Part B premiums deducted from Social Security benefits, any increase in Medicare premiums cannot cause a reduction in the net Social Security benefits received. The dollar amount increase in premiums cannot be more than the dollar amount increase in benefits.

The hold harmless rule doesn’t apply to the surtax.

The surtax can cause a reduction in your net Social Security benefits.Your MAGI is computed starting with adjusted gross income (AGI), which is on line 11 of the front page of the 2020 Form 1040. To arrive at MAGI, the AGI is increased by any tax-exempt interest income, EE savings bond interest used for education expenses and excluded foreign-earned income you received.

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, which are reported on Schedule 1 of Form 1040.

Frankly, few retirees qualify for the deductions from AGI, unless they’re self-employed. So, for most people the 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 after the conversion.

But after that, taking money from a Roth IRA instead of a traditional IRA should reduce income taxes and the surtax.It is best to do conversions more than 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.

A popular strategy is to convert enough each year to keep you from drifting into the next higher income tax bracket and IRMAA threshold.

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 gains already taken 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 share-holders. Other funds consider taxes in their strategies and minimize distributions each year. Tax efficiency can be found in a fund’s prospectus and 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 72.

But there are times when you might need extra spending money and have a choice of 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 from triggering or increasing the Medicare premium surtax.