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Help Your High-income Senior Clients Plan for New Tax Complexities by Rich White Discuss this and other issues in the new FreeERISA Message Boards     Return to Prospecting & Sales Insight See the new columns by Klein and Lovas.

Help Your High-income Senior Clients Plan for New Tax Complexities

Income tax planning is a complex chore for most high-income people. But for one part of the affluent population, retired people age 65 and up, it will soon become an even greater challenge.

With the help of a tax preparer and a pocket calculator, most taxpayers under the age of 65 can estimate their marginal tax rates in a few minutes, and it is rarely higher than about 40%. For older affluent taxpayers, even the most sophisticated tax advisors will soon have trouble deciding the effective marginal tax rate. If they succeed, they may not believe their eyes.

How soon will this happen? January 1, 2007. Mark it down as a day that will live in infamy for advocates of “tax simplicity.” On that day, the top marginal tax rate paid by some seniors could increase to as high as 140%+ on up to four separate slices of income, as we will show.

Fortunately, there will still be effective planning strategies for helping affluent seniors reduce taxes while simplifying the new tax complexities that Congress has created exclusively for people age 65 and up. These strategies will be evaluated herein.

Income-Relating of Medicare Part B Premiums

Now is the time to become familiar with a new term, “income-relating,” which will take effect on 1/1/07. Based on the Medicare Prescription Drug, Improvement and Modernization Act of 2003, higher-income Medicare participants will now pay substantially higher Part B premiums than those with lesser incomes. The definition of higher-income, for this purpose, begins at $80,000 of modified adjusted gross income (MAGI) for single filers and $160,000 for joint filers. Based on three additional higher income tiers defined by legislation, the Part B premium increases in increments until (at the highest level) it will be three to four times what mainstream retirees pay.

Income-relating is a cornerstone in Congress’ effort to shore up the tottering financial structure of Medicare. Of course, Social Security also will need an overhaul at some point, so the same concept could easily be ported over to Social Security benefits in the future. The 2003 legislation has given the IRS limited authorization to share seniors’ income tax data with the Social Security Administration, so that both agencies can be sure seniors pay the Part B premiums they should.

All this has occurred while Republicans, the traditional friends of high-income folks, have occupied the White House and controlled Congress. You may suspect that it could get even worse for high-income seniors if a Democratic administration get its hands on income-relating. Already, a planned five-year phase-in of the Part B premium increase, authorized under 2003 legislation, has been shortened to a three-year phase-in (2007-09) by the Deficit Reduction Act signed on 2/8/06.

Why is the government so anxious to get its hands on the incomes of affluent seniors?

When income-relating of Part B premiums fully phases in during 2009, it will affect about 6% of all Medicare participants, according to the Henry J. Kaiser Family Foundation. High-income seniors have become an easy target for politicians in both parties who want to shore up federal entitlement programs, because the voting influence of this group is minimal. Meanwhile, AARP’s membership has become too broadly-based to spend energy defending the wealthiest segment. In short, high-income seniors have become a politically vulnerable group. All the money they’ve diligently managed to save for retirement has become duck soup for politicians who must find new revenues.

New Realities in Tax Planning

Higher Part B premiums will have a strange new kind of hit on high-income wallets. Since working high-income taxpayers have paid 1.45% withholding for Medicare for years (2.90% for the self-employed), some will think of it as a continuation of wage withholding into retirement. Because Part B premiums usually are deducted directly from Social Security checks, this will feel like a reduction in Social Security benefits to many retirees.

But for seniors who want to plan wisely, the best way to see this concept is as an additional federal tax on income. Actually, it’s four new federal income tax brackets that each are as wide (in dollars) as the incremental increase in Medicare premiums at each of four MAGI levels. Each of these new brackets will have the same federal tax rate, 100%, in addition to all other income taxes. The tables below summarizes.

 *  Compared to a Medicare-eligible taxpayer earning MAGI less than $80,000 single or $160,000 joint. Estimates are from the Senior Citizens League based on 2009 Part B premiums per person.

For example, a single filer with MAGI of $105,000 will pay estimated Part B premiums annually that are $1,550 more per year ($620 in the first increment + $930 in the second increment) than a modest-income person. The first increment of extra premiums is triggered at MAGI of $80,000 and the second at MAGI of $100,000. The first new 100% bracket applies on MAGI between $80,000 and $80,620; 2) the second on MAGI between $100,000 and $100,930. The size of each 100% brackets (in dollars) doubles for joint filers. 

When viewed as an income tax, this new concept breaks with U.S. tradition in several ways. It’s the first time any group has been singled out for higher federal tax rates just because of age – 65+ in this case, the ages of Medicare eligibility. Secondly, it’s the first time a 100% federal tax rate has been levied on any range of income. When these four new 100% brackets are combined with regular federal and state income tax and the impact of income on the taxable portion of Social Security benefits, the total combined tax impact (within the four MAGI ranges defined above) could be 140%!

It Could Get Even Worse 

To make matters worse for affluent seniors, the above estimates of 2009 Part B premiums by the Senior League should be considered “best case.” Under another provision of the same 2003 act, the general U.S. tax revenues available to fund Medicare are capped at 45% of total cost. That cap is expected to be exceeded by about 2011-2012, and this will result in proportionately higher Part B premiums for everyone. Within a decade, it is possible that the highest income taxpayers could be shelling out $10,000 per person per year for Medicare Part B premiums. That compares to $1,062 that all Medicare Part B participants are paying for 2006. Also, it is possible that Congress will have to reduce the MAGI thresholds of the four new 100% brackets in the future, just to keep Medicare solvent.

Affluent seniors who wish to escape this tax mess by opting out of Part B will face a healthcare version of Catch-22. After an annual deductible, Part B covers 80% of doctor fees, outpatient services, physical and occupational therapy, x-rays, lab tests, and some home health services. There are heavy financial penalties for deferring enrollment in Part B beyond the age of first eligibility (65). Also, the Medigap programs that most affluent seniors purchase to supplement Medicare are designed to dovetail with Part B. For example, all standard Medigap plans cover the Part B 20% coinsurance. Opting out of Part B will not be a good fit or logical option for most high-income seniors.

Planning for a New Tax Landscape

The flip side of this coin is that many high-income seniors have great flexibility to plan the MAGI that they report on their 1040s each year, and there is no time to lose in helping them understand these new provisions and prepare for them. The MAGI upon which Part B premiums will be based each year will be reported in the second prior year. For purposes of calculating 2007 Part B premiums, 2005 MAGI will apply, in most cases.

For most taxpayers, MAGI is defined for this purpose as Adjusted Gross Income plus tax-exempt (municipal) income. The only modifications to AGI that apply in this case add back interest on U.S. Savings Bonds (used for higher education) and certain non-U.S. source income. (No part of Social Security benefits is included in this definition.)

For tax planning purposes, it will become more advantageous for some seniors to only generate the income from savings and investments that they actually need for current spending. Here are a few ideas you can use to help them:

• Taxable bonds and bank accounts may look less inviting when they pay interest that is hit with marginal rates above 100% in specific ranges.
   

• Municipal bond income may no longer be quite as attractive, either, since in some ranges up to 100% of “tax-exempt” interest effectively could be taxed.
   

• Keeping large amounts of assets in retirement plans or IRAS also could become more costly, because minimum distribution requirements can trigger high marginal tax impact.
   

• Solutions that stand to benefit from “income-relating” include tax-deferred annuities and Roth IRAs. Both have two benefits in common: 1) they allow seniors to defer receipt of income until years in which withdrawals have the lowest tax impact; i.e., each December, advisors can suggest withdrawals in amounts that will not push seniors into one of the new 100%+ brackets; and 2) normally, these solutions do not require withdrawals until the owner’s death, and they do not require any federal tax reporting until withdrawals are made. In effect, tax-deferred annuities and Roth IRAs are private assets that can avoid the prying eyes of government for the duration of the owner’s life.
   

• Under current law, Roth conversions (from Traditional IRAs) are allowed only for taxpayers with Adjusted Gross Incomes not exceeding $100,000, including the converted amount less any required minimum distributions. With planning, it may be possible to reduce AGI below this threshold in a few years, so that a series of conversions can be made.
   

• Under proposed new legislation that could be enacted any day, the AGI limit on Roth conversions would be eliminated.
   

• Life insurance may become a far more attractive solution for retirement income planning, because it offers the same advantages of tax-deferred annuities and Roth IRAs (described above) while also providing tax-free access to income through policy loans.

Most Affluent Seniors Eventually Will Be Affected

Income-relating will probably become a centerpiece for future efforts to fix government entitlement programs and reduce the federal deficit. You can expect that it will eventually touch a majority of affluent seniors in ways that cut government benefits or cost extra taxes.

As more seniors learn that they can control the amount of taxable income that they report each year without sacrificing retirement lifestyles, the IRS may take steps to require that seniors report specific assets, in addition to income. Municipal bonds are an example of an asset in which the IRS already requires extensive record-keeping that must be produced in an audit. 529 Plans could become another target, in part because it would not be hard for the 50 states to share information on account ownership with the IRS.

Think long-term in planning for your clients by helping them take advantage of assets that offer the advantages of discretionary income timing and asset privacy. Tax-deferred annuities, Roth IRAs and life insurance may be several of the best examples.

For Additional Reading and Research on the Web

The text of the 2003 legislation authorizing the Part B premium increase:

http://aspe.hhs.gov/mits/text/titleVIII/811.html

For an excellent overview of Medicare financing and premiums prepared in PowerPoint by Tricia Neuman of the Henry J. Kaiser Family Foundation:

http://www.kaiseredu.org/uploadedFiles/Medicare_101.ppt

For a report on the higher premiums by the Senior Citizens League, including estimates of 2009 premiums at all four MAGI tiers:

http://www.tscl.org/NewContent/102589.asp

For a detailed report on the 2003 legislation, including the estimate that 6% of Medicare Part B participants will be affected after full phase-in:

http://www.kff.org/medicare/upload/Prescription-Drug-Coverage-for-Medicare-Beneficiares-An-Overview-of-the-Medicare-Prescription-Drug-Improvement-Act-2003.pdf

Why Are My Part B Premiums Increasing?

The explanation of why Part B premiums of high-income seniors are increasing is far from simple. Here is a summary:

• Medicare spends more than $300 billion per year, with most of the money provided by two trust funds:
   
  • Part A, the Hospital Insurance Trust Fund, accounts for about 60% of all spending. Payroll taxes (plus interest earnings) and the taxation of Social Security benefits fund almost all of Part A’s cost.
     
  • Part B, the Supplementary Medical Insurance Trust Fund, accounts for most of the other 40%; about 75% of Part B’s costs are paid from general U.S. Treasury revenue, the other 25% comes from Part B premiums paid by Medicare participants.
     
• The Medicare Prescription Drug, Improvement and Modernization Act of 2003 mandates that Part B premiums of higher-income seniors must pay a greater share of Part B’s total costs than the current 25%. Subject to a three-year phase-in schedule (2007-2009), these targets will apply for single filers:
   

  • MAGI of more than $80,000 up to $100,000:           35%

  • MAGI of more than $100,000 up to $150,000:         50%
     
  • MAGI of more than $150,000 up to $200,000:         65%
     
  • MAGI of more than $20,000:                                 80%
     

• In each case, MAGI limits for joint filers are doubled, and the same percentages apply. 
   

• In the future, Part B premiums of high-income seniors will be directly linked to the solvency of the Part B trust fund. If Part B medical costs keep increasing, so will the premiums of affluent seniors. The calculation of the “premium subsidy” (i.e., the dollar amount of each affluent taxpayer’s premium payable from general revenues) will actually be made monthly. The Part B premium each month will represent a bill for the balance of the full premium due; i.e., the total cost to the Part B trust fund allocable to each Medicare participant, less the subsidy. Thus, premiums will change in the future not only among senior taxpayers according to income but also, among the most affluent segment, from month to month. To keep affluent seniors from juggling their current incomes to reduce premiums, the MAGI test will be made on a two-year look-back basis; i.e., income reported in the 2005 tax year will be used to determine 2007 premiums. Therefore, forward planning will become more important.

Note: As with all columns carried in the Sales Insight section of freeERISA.com, they represent solely the opinion of the columnist and not necessarily the opinion of freeERISA.com.

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