For many, health insurance and health care services are likely to be among the largest expenses in retirement. The fact that health care costs have historically risen faster than the rate of overall inflation can be a source of concern for retirees and those contemplating retirement.
Furthermore, unlike other nondiscretionary costs during retirement, health care spending is ultimately a wild card, as it is obviously hard to forecast how long you will live and what the quality of your health will be as you age.
The intent of this post is to add some perspective to this often-daunting topic, as well as to outline a few concrete steps you can take to mitigate health care risk. For those on the verge of retirement, I’ll also address how I can help you by incorporating the potential cost of health care into a well-formulated financial/retirement plan, and then stress-testing it.
Rough Estimates
First, let’s take a broad view of the estimated amount of savings needed, on average, to cover health care costs in retirement. One oft-cited source is a study that is updated annually by the Employee Benefit Research Institute (EBRI). It estimates the savings needed to cover out-of-pocket costs not covered by Medicare (in other words, Medigap insurance premiums, Medicare Part B premiums, Medicare Part D prescription drug plan premiums, and out-of-pocket drug expenses).
According to EBRI’s most recent 2021 study, a 65-year-old man needs, in today’s dollars, $79,000 in savings, and a 65-year-old woman needs $103,000, to give each a 50% chance of having enough money to cover health care expenses in retirement. To give each a 90% chance of having enough savings, the amounts are $142,000 for a man and $159,000 for a woman.
Of course, one must bear in mind that EBRI’s figures focus on average or median costs. Individual costs can vary significantly due to differences in personal health, location, and insurance coverage. Moreover, the figures above assume median prescription drug expenses. For those in the 90th percentile (that is, the top 10% tier) of drug expenses, the savings required for a 90% chance of success for a couple is $361,000. And finally, EBRI’s analysis does not factor in the savings needed to cover long-term care expenses, which can be another major concern for retirees (I address these expenses later).
But Other Costs May Go Down
While these figures, and the wide range of possible ultimate outcomes for any one individual or couple, can be unnerving, it’s important to bear in mind the bigger picture: Although health care expenses may consume a larger share of total spending, particularly later in retirement, overall spending tends to decline.
More specifically, some expenses typically disappear during retirement, with some vanishing immediately and others tending to diminish over time. A few examples include retirement account contributions, payroll taxes (Social Security taxes cost workers 6.2% of their pay up to $147,000 in 2022, and Medicare taxes are 1.45% of wages, with no limit), commuting costs, life insurance premiums, possibly one’s mortgage payment, and family expenses (namely, feeding, clothing, and transporting family members other than you and your spouse).
Indeed, according to the most recent Consumer Expenditure Survey of the Bureau of Labor Statistics, average U.S. household spending peaks between the ages of 45 and 55. After 55, spending declines in most categories, with health care and charitable contributions and gifts being the notable exceptions. Among the categories with dramatic reductions in spending are apparel and services (spending in these categories declines by almost half by age 80), transportation, and mortgage payments. These trends are consistent with an annual study of spending patterns conducted by J.P. Morgan Asset Management, based on credit card data from more than 5 million J.P. Morgan Chase Bank households (with all personally identifiable information removed). Their data show an overall downward trend in average post-retirement spending in real terms that levels out at around age 85.1
With all of this said, there are several ways to curb retirement health care costs, beyond the obvious ones of establishing good health habits and saving more. A few examples are:
- Health savings accounts (HSAs): HSAs allow you to put aside money for qualified medical expenses and save on taxes at the same time. Contributions to an HSA are deductible for federal taxes; earnings and withdrawals are also exempt from federal taxes.2 Distributions that aren’t used to pay medical expenses are taxed as gross income and are subject to an additional 10% federal penalty tax until you reach age 65.
To be eligible to open an HSA, you must be covered under a high-deductible health plan (in 2022, this means a deductible of at least $1,400 for single coverage or $2,800 for family coverage). In addition, you can’t be covered by any other health plan, entitled to Medicare benefits, or claimed as a dependent on another person’s tax return. The contribution thresholds for 2022 are $3,650 for single coverage or $7,300 for family coverage, plus an additional $1,000 “catch-up” contribution if you’re age 55 or older.
Given these thresholds, HSAs are most beneficial for younger investors who have more time to accumulate savings before retirement. To optimize the tax benefits, consider paying for current medical expenses with cash and letting the funds in the HSA continue to compound tax-free until retirement.
- Mind your MAGI: For those who are already receiving, or who will shortly receive, Medicare benefits, it can be beneficial to minimize one’s modified adjusted gross income, or MAGI (adjusted gross income plus any tax-exempt interest) to the extent possible. This is because Medicare Part B and Part D premiums are means-tested; if the MAGI exceeds $91,000 for single filers or $228,000 for joint filers, premium surcharges apply. Furthermore, there is a two-year lag between the latest available tax data and Medicare premiums, meaning that 2022 MAGI brackets (which determine 2022 Medicare premiums) are based on 2020 income.
So what are some steps retirees can take to keep their income under the aforementioned thresholds—or at least at one of the lower premium rungs?
First, withdrawals from a Roth IRA, a Roth 401(k), or an HSA are not included in your MAGI. Thus, particularly with regard to Roth accounts, it may be worth funding these during your working years, even if you’re in a relatively high tax bracket, as this “tax bucket diversification” may provide some flexibility during retirement.
Another way to minimize your MAGI, assuming your overall resources are sufficient, is to donate all or part of your required IRA minimum distribution to charity. Those aged 70½ and older can now transfer up to $100,000 annually from their IRAs to charity.
Finally, if you incur a premium surcharge after you retire, you may be able to reduce it. Again, there is a two-year lag between the most current available tax data and Medicare premiums; thus, the premium for a retiree starting Medicare in 2022 will be based on 2020 income. You may be able to contest a surcharge due to a “life-changing event”—which includes retirement—and ask Social Security to use your more recent income instead as the basis for your Medicare premiums.
- Shop around: Studies have found that premiums for identical coverage for the same person can vary significantly. Indeed, a 2017 an analysis by eHealth found that 90% of those enrolled in Medicare prescription drug coverage could be overpaying because they didn’t shop around.
Beneficiaries should take advantage of the annual Medicare open enrollment period, which starts in mid-October each year. Despite the dull and often tedious process of shopping for insurance coverage, Medicare’s website contains useful information, including an online plan shopper. Another resource is the State Health Insurance Assistance Program (SHIP), a federally funded program that provides free local health coverage counseling to people with Medicare.
How About Long-Term Care?
The risk of needing long-term care is another major retirement planning concern. This topic alone—and, more specifically, long-term care insurance (LTCI)—could easily warrant its own post. In large part, that’s because LTCI has been subject to much debate, given that it can be notoriously complex and expensive. Indeed, many carriers have dropped out of the market in recent years after overestimating the number of lapsed policies and underestimating costs and policyholder life expectancies. This has led to steep premium increases even for existing policyholders.
Despite the insurance industry often promoting LTCI as a “must have,” one should bear in mind that insurers expect to make a profit. Or, stated differently, buying insurance is, on average, expected to be a losing proposition from a financial perspective: Insurers expect to pay out less than their customers pay in premiums. And when it comes to LTCI, these premiums are not inexpensive.
Furthermore, contrary to popular belief, most people do not spend lengthy periods of time in a nursing facility. Consider the following data points:3
- Two-thirds of all men and one-third of all women age 65 and older will never spend a day in a nursing facility.
- Most nursing facility stays are brief—only about 10% of men and 25% of women age 65 and older spend more than a year in a nursing facility.
- Only 10% of all nursing facility residents will stay longer than three years.
- More than half of all nursing facility stays last six months or less. The average stay of those who enter a custodial care facility is about 18 to 20 months.
- Some people with LTCI polices may never have their coverage kick in because, under certain circumstances, Medicare covers the full cost of care in a skilled nursing facility for 20 days and partial costs thereafter, up to 100 days.
Unfortunately, in most cases, there’s no simple answer as to whether purchasing LTCI makes sense. Again, from a financial perspective, the odds are small that most people will ultimately need and collect benefits for a long enough period to justify the premium costs. That said, LTCI can provide added peace of mind for those who can afford a good policy. LTCI can also be a solution for those who want to protect resources or leave an inheritance, safeguard the finances of spouse/domestic partner or dependent(s), and/or have the flexibility to choose the type of care and the place where care is received. An oft-cited resource to help determine the suitability of LTCI is the National Association of Insurance Commissioners’ brochure, A Shopper’s Guide to Long-Term Care Insurance, which, indeed, many states require insurance companies or agents to provide when one is considering a policy.
In light of the LTCI market’s aforementioned challenges, so-called “hybrid plans” have become an increasingly popular alternative. These include cash value whole or universal life insurance policies, as well as tax-deferred fixed annuities, that can be purchased with LTCI riders. However, as with most things in life, there are trade-offs to consider. In the case of cash value life insurance, steep premium costs, either paid in a lump sum or spread over a certain period of time, could put these policies out of reach for many. Furthermore, paying the premiums rather than investing the premium amounts over time could mean forgoing investment returns, otherwise known as an “opportunity cost.” This is also true for the annuity option, which could lock up a large amount of money that will then earn modest returns.
How I Can Assist
Whether you are evaluating possible funding options for long-term care or determining how to factor health care costs into your retirement plan, I have many years of experience tackling these issues for clients. And while health care costs may be the most difficult retirement expense to predict, I use robust third-party financial planning software that can model various scenarios, including forecasting Medicare premiums, if need be, based on one’s MAGI, incorporating a specific inflation rate assumption for overall health care expenses, and performing a long-term-care needs analysis.
Of course, any model is only as good as its input and assumptions. But with the benefit of experience and informed judgment, I can help you put a plan in place to manage your health care expense burden and thus hopefully lighten the load for a more comfortable retirement.
- Retirement by the Numbers, J.P. Morgan Asset Management, 2021.
- States can choose to follow federal tax treatment guidelines for HSAs or establish their own. Most follow federal tax guidelines but, for instance, California is currently not one of them.
- Matthews, Joseph, Long-Term Care: How To Plan and Pay for It, NOLO Press, 2020.
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