Today’s missive comes from a sharp-eyed reader who is wondering about how to mitigate what they are paying for their Medicare and while you might think this is an issue for the old codgers amongst us, this is really something that investors of all ages should plan for. Medicare costs and tax planning start at the point someone opens a non-retirement account whether they realize it or not.

Let’s start with some Medicare premium basics.  In an effort to shore up the Medicare system, Congress passed the Medicare Modernization Act of 2003 instituting the Income-Related Medicare Adjustment Amounts (IRMAA). IRMAA puts a surcharge on what retirees pay for Medicare based on their income and here’s where the fun begins. There are five levels of surcharge on top of the base premium of $164.90 (2023) and there are different income categories based on whether you are married or not.  However, IRMAA uses what’s called your MAGI (Modified Adjusted Gross Income) and while that’s not something you are going to find on any tax return, it is fairly easy to calculate. Your MAGI takes your Adjusted Gross Income and adds back your non-taxable Social Security benefits and your tax-exempt interest, both of which are entered earlier on your Form 1040. And which year’s tax return does this all apply to? Funny you should ask – the tax return from two years before your current premium year which means your Medicare premiums for age 65 will use your tax return from when you are age 63 and that might not be top of mind when you are moving from an accumulation portfolio to a distribution portfolio in anticipation of an impending retirement. OK, those are your basics – on to your investments.

For many, many years, all we had for investment options were actual stocks, actual bonds, and mutual funds and most savers used mutual funds in an after-tax account that complimented their company retirement plans. And, while this was better than not saving, these mutual funds have a bit of a drawback when they are outside a qualified (pre-tax) account. Nearly every year, whether we want them or not, those mutual funds kick off something called “capital gains distributions.” While we are young, we take it in stride – little extra tax bill… so be it. When we are using Medicare for our health insurance, those capital gains distributions have a double bite – not only are there more taxes on our 1040 return but too many capital gains and we end up paying more for our Medicare premiums.

Here is where the weeds get a little thicker….  If you’ve been fortunate enough to either accumulate or inherit a sizeable after-tax investment account, not only might you have those pesky capital gains distributions, you’ll probably also have embedded capital gains on those investments (the difference between what you paid for that investment and what that position is now worth). While we love to look at our accounts and see all those green “worth more than it was before” numbers, each of those green numbers is an embedded capital gain we are going to need to pay tax on when we rebalance our portfolio, and those numbers can also increase our Medicare premium if we need to sell investments to fund something in retirement. What to do… What to do…

The first thing to do is to remember that when Kitty gently suggests harvesting some of those gains in your portfolio, no matter your age, she isn’t just talking to hear herself talk. Even if you absolutely love a particular position, “resetting” the basis of that account can save you money down the road. In an ideal investment planning world, we would, from our earliest investing years, harvest a little gain every year, hold our noses, and pay a little capital gains tax then reinvest those dollars, ideally in an exchange-traded fund that is less likely to kick off those capital gains distributions.

Let’s say you didn’t do that throughout your early investing life.  You still have several choices. 1) In the years before you reach age 62, you could assess your portfolio and make some portfolio changes, pay the gains, and know that you won’t have as many of those capital gains embedded in your portfolio later in life. 2) At some point after the age of 63, you could rip off the Band-Aid in one year and sell vast chunks of your portfolio, knowing that you’ll have one year where your Medicare premiums will be much, much higher but that it will drop down the following year and potentially for many years to come. 3)  You could recognize that the price you are paying for your coverage all the way up to Tier 4 is still less than what the average non-retired American pays for health coverage and be at peace with the fact that you have coverage.

When it comes to Medicare premiums, there are certainly things you can do but there are few options that don’t feel slightly uncomfortable – not a great situation but also not the worst possible situation in life.