At times, important new terms slip into our financial vocabulary without much fanfare. One such example is "income relating," as it relates to Medicare. If you had paid attention to the fine print of U.S. statutes, you might have noticed that this term made its debut for in the Medicare Prescription Drug, Improvement and Modernization Act of 2003. However, it did not become effective until 2007, and the high-income enrollees that it affected have felt its impact ever since.
Income relating means that the U.S. government will take a retiree's reported income into account when determining the cost or value of "entitlement" benefits. It is similar to the better known term "means-testing" and is applicable to retirees with high income. Beginning in 2007, this concept increased the Medicare Part B premiums for high-income retirees, effectively reducing the value of their Medicare entitlements.
A New Kind of Effective Income Tax
In creating this concept, Congress was careful to separate it from the income tax payment structure. Seniors do not pay higher Medicare premiums to the IRS. Rather, in most cases, these premiums are deducted from Social Security benefits. However, income relating is a devilishly complex new type of income tax in disguise for three reasons:
- It is aimed at one segment of the population only – Medicare recipients – who generally are age 65 or older.
- Within four narrow new taxable income tiers, it has the impact of confiscating 100% of reported income in addition to the impact of regular income tax. That creates perhaps the highest effective tax brackets that any U.S. taxpayer has ever faced.
- It has a delayed impact. For example, the income that high-income seniors report on IRS Form 1040 for the year 2013 will determine their Medicare Part B premium costs for the year 2015.
|Example - Opting Out of Medicare Part B
To understand the kinks all this can throw into a tax planning process, imagine this example: John and Jane Doe, a high-income senior couple, are meeting with their CPA for a year-end tax planning session. The advisor says: "I've just made a preliminary assessment of your modified adjusted gross income (MAGI) for the year, and it is $204,000. But I must warn you that for any income you report above this amount, you will pay your regular federal and state income tax. In addition, your Medicare premiums will increase two years from now dollar-for-dollar for about the next $1,000 of income. So, any income in that tier will actually cost you more than it's worth." John and Jane must then decide whether it makes better financial sense to opt out of Medicare Part B.
Currently, there are five such tiers, and they are summarized for 2015 premium in Figure 1, below.
|Tier Begins at MAGI* of…||Additional Monthly Medicare Part B Monthly Premium/Person|
|For Single Filers||For Joint Filers|
|>$85,000 to $107,000||>$170,000 to $214,000||$42.00|
|>$107,000 to $160,000||>$214,000 to $320,000||$104.90|
|>$160,000 to $214,000||>$320,000 to $428,000||$167.80|
|* The MAGI thresholds will be inflation-indexed in future years.|
How to Avoid Tax Tiers
Affluent seniors who wish to escape this impact by opting out of Part B face a healthcare catch-22. Part B covers a smorgasbord of widely used services including doctors, outpatient services, physical and occupational therapy, x-rays, lab tests, and some home health services. The "medigap" policies that most seniors purchase to supplement Medicare are designed to dovetail with Part B and can't normally be accessed without Part B in place. Therefore, opting out rarely works.
In addition, although there are ways to avoid tax issues on municipal bonds, seniors can't use municipal bond income to avoid one of the punitive tiers. Even if this income is tax-exempt on the 1040, it is specifically included in the MAGI test for Part B income relating.
One other piece of bad news for seniors: The legislation behind Part B income relating authorizes a data-sharing arrangement between the IRS and the Social Security Administration that help Social Security estimate premiums each year and deduct them from benefits. This same cozy arrangement could make it easier for Congress to link Social Security retirement benefits to reported income, too, at some future date.
Is There Any Good News?
Is there any good news in this picture for high-income seniors? Definitely.Year-end tax planning will become more important than ever. It just won't pay to receive income in one of those terrible tiers, if it can be avoided. Tax-advantaged techniques such as Roth IRA conversions may make more sense for high-income seniors. Conveniently, these conversions became available to the affluent for the first time in 2010.
It's worth noting that the taxable portion of Social Security benefits has been "income-related" for some time, and several leading voices in Congress are calling for high-income seniors to sacrifice some of their future benefits to secure the system's long-term solvency.
The Bottom Line
The bottom line of income relating may be that you can never retire from income tax planning. Previously, that has meant trying to keep the IRS out of your pocket. Now, it may mean Medicare and Social Security, too. For more on how Medicare affects higher income seniors, see Medicare Changes for 2016.