That Traditional 401(k) is bad for your health
The alarm has been sounded, we have been told that Social Security retirement may go bust and this has prompted a renewed call for employees to utilize Traditional 401(k) plans in order to save more for their retirement.
The question though; What if that Traditional 401(k) plan winds up being bad for your health?
Yes, Traditional 401(k) plans on the surface look great. An employee can defer a portion of their salary into a tax deferred account. This lowers their current taxable income, while all contributions and earnings may grow (and compound) tax free. If the employer provides a company match, they will be able to get a tax break too for that match too.
Retirement planning education usually focuses on the tax savings today, with the hope that the savings will be larger later. This also assumes that a retiree will be in a lower tax bracket, which may be a dangerous assumption.
What will likely occur with employer sponsored plans is employees who take advantage of traditional 401(k) plans are unknowingly setting themselves up for the possibility of higher health costs as well lowering their Social Security benefit in retirement.
How is this possible?
Medicare rules changed in 2003 and then again in 2010. When a person retires and is no longer covered by an employer’s or spouse’s employer health plan, to receive any Social Security benefit, they must enroll into Medicare too.
The other regulation that is often neglected by most financial advisors is Medicare, through the Income Related Monthly Adjustment Amount (IRMAA), will assess a surcharge to specific parts of Medicare coverage if too much income is generated while retired.
And, yes, income is any distribution from any Traditional 401(k) plan or tax-deferred retirement accounts. It also includes Social Security benefits, dividends, most capital gains, wages. and taxable and tax-free interest.
The regulations require that the IRMAA surcharges on your Medicare premiums due to higher income be automatically deducted from any Social Security benefits being received.
But who will this impact today?
Thankfully, not that many people as the IRMAA brackets have been set at a high number for many retirees. In 2018, the first surcharge bracket does not start until a person reaches $85,000 in income. For a couple the amount is double ($170,000).
However, now is not the time to ignore this for those retiring in the next 10 years or longer.
We can calculate future values of savings using an assumed, modest return. We know that, thanks to the Social Security Board of Trustees, the future inflation rate for Social Security’s cost of living adjustment (COLA), which is to be no higher than 2.6 percent for the foreseeable future.
Using this data, we can predict the likelihood of who will enter Medicare’s IRMAA due to savings using the following example:
- 55 years old today.
- $60,000 in savings already in a traditional 401(k) plan.
- Is contributing $10,000 into their traditional 401(k) plan, including the company match.
- Receives a 5 percent rate of return on the investments inside the 401(k).
- Planning on delaying Social Security until age 70 with a COLA of 2 percent.
- Earns $85,000 in wages.
By age 81 the person in this example will generate enough income to enter the first IRMAA bracket thus increasing their health costs as well as lowering their Social Security benefit.
If they happen to live until age 90 they will enter the second IRMAA bracket in that year too.
In total, if Medicare’s inflation rates remain constant from historical data this person will pay about $80,000 in extra premiums for their health coverage. This amount will also come directly from their Social Security benefit too.
Perhaps we want to reevaluate the position that this shouldn’t impact too many people. Obviously, for those who are saving more, earning more and investing more they too will hit IRMAA, but it will be sooner.
The easiest solution to this problem, besides meeting a financial professional who understands income tax returns as well as Social Security and Medicare laws, is to choose the Roth option in the employer sponsored retirement plan.
Roth accounts, though there are no tax savings today, do not require mandatory distributions in retirement. Qualified distributions are not only tax free, but do not count toward Medicare’s IRMAA calculation.
The drawback of a Roth 401(k) is employer contributions. The employer matches with pretax money and the Roth contributions are with after tax money. You cannot commingle the two. But the new tax laws may make this a moot point for many Americans.
The choice is yours: continue to use a Traditional 401(k) and see a tax levied on you through Medicare’s IRMAA while losing the bulk of your Social Security benefit or pay taxes today and use a Roth.