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Managing Medicare's Costs

Medicare, income taxes and healthcare costs

One reason people are often surprised at the cost of healthcare in retirement is that they typically pay all of these costs with after-tax dollars. As a result, they find the cost of their healthcare is 15% or 20% more than they’d expected. For many, this is a change from their working years when they had a variety of tax-favored ways to pay for medical expenses.

Most important, when they were working they benefited from the fact that employers can deduct the entire cost of health insurance for their workers. Over the years, this full deductibility encouraged companies to provide comprehensive health insurance, although this coverage has eroded in the past decade or so because of steep rises in the cost of healthcare. Even so, the Kaiser Family Foundation’s Employer Health Benefits 2011 Annual Survey found that large employers pay two-thirds of current workers’ health insurance premiums, and that 98% of the plans include prescription drug coverage.

Also, when they were still working, many retirees had access to flexible savings accounts or employer-sponsored health reimbursement accounts, both of which enabled them to spend before-tax dollars for their deductibles, co-payments and co-insurance requirements.

For the most part, those opportunities disappear once people retire. The primary exceptions are retirees who have employer plans that supplement Medicare. These individuals belong to a shrinking minority — the Kaiser survey found that only 26% of large employers are now offering retiree supplements (page 5). And even people with employer plans will likely have to pay all of their premiums and other out-of-pocket costs with after-tax money. Thus retirees are sometimes dismayed when they understand how much more healthcare will cost them.

Here’s an example: a recently retired 65-year-old couple expects to have an effective tax rate of 20% (federal and state) next year. Each spouse will pay the standard Part B premium in 2012, so their combined Part B premiums will be about $2,400. They will, however, need $3,000 in income to pay those premiums, since $600 will go to taxes. But it’s not just Part B premiums. In planning for retirement, this same couple had estimated that during the course of their retirement they would spend about $230,000 on healthcare, using Fidelity Investments’ most recent estimate.

But now they realize that if they spend $230,000 on healthcare, it will require $287,500 in income. Even if they are fortunate enough to have an employer plan to supplement Medicare and estimate that they will spend less than Fidelity’s number, they will need to inflate this lower estimate to account for taxes.

There are a few narrow exceptions to the rule that retirees’ out-of-pocket costs are paid with after-dollars. The first is for retirees who have Health Savings Accounts, which allow them to spend pre-tax dollars for eligible expenses. Fewer than two percent of people 65-and-older have these accounts, though. And because HSA’s were not available before 2003, the limited number that do exist have small balances. While average account balances are not tracked after people retire, an analysis by the Employee Benefit Research Institute found that in 2010 Individuals ages 55−64 had an average value of only $1,791 in their HSA’s (page 7).

The other exceptions are also not available to most people. A few companies fund a health reimbursement account for retirees, usually with a one-time contribution that’s based on years of service. Also, death benefits from life insurance policies, which are not subject to income taxes, can be used for any purpose. Otherwise, there are almost no income sources that shield retirees from taxes. Some people may believe that they are using non-taxed dollars when they pay for healthcare with funds from a Roth IRA or from their contributions to a non-deductible IRA, but that money was taxed earlier.

One tax-saving tactic that some retirees have available to them is the deduction for out-of-pocket medical costs that exceed 7.5% of adjusted gross income. If a retired married couple has $100,000 in adjusted gross income and $8,000 in medical expenses, they can deduct $500 ($8,000 minus 7.5% of $100,000). And if their adjusted gross income is $85,000, they can deduct $1,625 ($8,000 minus 7.5% of $85,000).

In calculating this deduction, people can include most types of healthcare costs. Among the Internal Revenue Service’s long list of eligible medical expenses are Part B and Part D premiums as well as premiums paid for Medigap, Advantage, and employer plans. Also, co-payments for medical services and prescription drugs, dental costs, eyeglasses, acupuncture, and chiropractic treatments all qualify.

And, a portion of premiums paid for tax-qualified long-term care insurance policies are eligible expenses, as are most long-term care costs. The only health-related expenses that most retirees have that do not qualify are payments for non-prescribed drugs, vitamins, and supplements.

Three reasons that few retirees claim the medical expense deduction are: 1) they are among the two-thirds of taxpayers who don’t itemize deductions, 2) they do not know how much they pay for healthcare in a given year, and 3) even if they do have an idea of how much they pay for healthcare, they are unaware that some part of that may be deductible.

To benefit from the medical expense deduction, retirees will also need writeoffs in other areas — home mortgage interest, charitable donations, and state and local taxes. But if they already itemize or have enough deductions in other areas, they may be able reduce their tax bill by claiming the medical expense deduction.

Earlier this year a Kaiser Family Foundation study found that people enrolled in Medicare averaged paying 16% of their incomes in 2006 for out-of-pocket medical costs, which is well above the 7.5% cutoff point. That percentage has doubtless increased since 2006. Moreover, the 16% average tends to hide the extremes, which are represented by low-income people who pay 25% of even 30% of their incomes for medical expenses and very affluent individuals who pay only 1% or 2%.

The retirees most likely to benefit from the medical expense deduction are those whose annual incomes are between $60,000 and $100,000. In this group, the percentages of incomes spent for health care are usually between 4% and 10%. Especially likely to see tax savings are retirees in this income range who already itemize deductions but who have never calculated whether they may be able to claim the medical-expense deduction.

Even if a few years ago individuals determined that they could not use the medical-expense deduction, they may be able to do so now, since healthcare costs have risen perhaps twice as fast as their incomes. People who have expensive Medigap policies such as the popular Plans C and F are likewise good candidates for the deduction.

A 65-year-old couple with Medigap policies could easily have $8,000 in qualifying expenses. Let’s say that each spouse has a Medigap Plan F for which they pay combined premiums of $3,600 a year. Add to that their combined expenses for Part B premiums ($2,400) and prescription drugs ($1,500). Then add another $500 for dental and vision care to bring the total to $8,000. In this example, so long as this couple’s income is less than $106, 666, they can claim some deduction for medical expenses.

Retirees need to track their healthcare costs to know whether they qualify for the deduction. Individuals who do not currently itemize will also need to determine if the total of all their deductions – not just the medical expense deduction — make it worthwhile to itemize. For the 2011 tax year, the standard deduction for married couples is $11,600 ($5,800 for single individuals). If either spouse is age 65 or older, couples can add another $1,150 ($1,450 for single individuals).

The current 7.5% threshold for the medical expense deduction will increase to 10% beginning in 2017. But even the 10% number will not be out of reach for many retirees, particularly if they are older and pay sizable premiums. Most retirees will also have greater cost-sharing in future years as a result of yet-to-be determined changes to Medicare.

People can profit in at least two ways by tracking their expenses for healthcare. Besides possibly finding a medical-expense deduction, they will know whether their costs are rising faster than expected, or if one particular category of healthcare spending is growing at double-digit rates.

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