The potential costs and benefits of Medicare have a huge impact on retirement planning. For most folks, health-care costs are among the largest they will face in their retirement years. And, contrary to what many believe, Medicare is not free.
You do have to "pay to play." In fact, Medicare expenses can be substantial, particularly if you don't plan properly in your retirement budget. The more you know about the impact of Medicare on your plan, the more manageable those costs will be.
Medicare has many components and costs that need to be figured into the retirement-planning equation. There are three main parts to Medicare: Medicare Part A, which generally covers hospital care; Part B, covering doctor visits and outpatient services; and Part D, which covers most prescription medications. While Part A is prepaid by most of us through payroll taxes, Parts B and D are not. Instead, subscribers pay premiums priced on a sliding scale that is, in turn, based on income in retirement. (If you're wondering about Medicare Part C, click here.)
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The smart thing to do is figure those Medicare premiums into your retirement planning. That way, there will be no surprises. Whether you plan for these health-care costs or not, you'll still have to pay for them. And then you may find yourself dipping into your nest egg more often than you planned, leaving you short on money to live on—a bitter, but preventable, pill to swallow that you can avoid with effective retirement planning.
The best approach is to estimate your retirement income and resulting Medicare Parts B and D costs. Medicare uses specific information from your tax return to come up with an income number called the "Medicare modified adjusted gross income," or "Medicare MAGI." (A note of caution: The Medicare MAGI is calculated differently than MAGI figures used in various other aspects of retirement planning. Therefore, it is important to use the right calculation.)
Medicare MAGI may sound like a mouthful but it's fairly easy to figure out using your current tax return. Here's how you do it: Look at your 1040, or "Long Form," and add the Adjusted Gross Income amount found on line 37 to the Tax-Exempt Interest amount from line 8b. The total of those two numbers is your Medicare MAGI, based on your most recent earnings.
Medicare MAGI=Adjusted Gross Income (line 37) Tax-Exempt Interest (line 8b)
You can then use the sliding-scale income-bracket chart below to determine your annual Medicare Parts B and D costs—in this case, for 2013. Yes, the premiums do increase over time. Medicare MAGI income brackets, however, are fixed through 2019 and are therefore helpful for planning purposes. Remember that the listed premiums are for individuals; if you're planning for you and your spouse, double the numbers.
You can forecast your future Medicare MAGI number with projected Adjusted Gross Income and Tax-Exempt Interest figures you are likely to have in retirement, a worthwhile exercise to work through with your tax specialist and/or financial advisor. You can see from the table that when your Medicare MAGI throws you into a higher premium bracket, it can have a profound effect on your retirement budget.
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Once you have determined your Medicare MAGI, you would be wise to consider some scenarios that may impact your investment-planning strategy. This will help you further understand the impact that some types of investments can have on your Medicare MAGI and, therefore, on premium costs. For example, income from a Roth investment retirement account (IRA) is not included in the Medicare MAGI. Given that, it might be beneficial to include a Roth IRA in your retirement-savings strategies.
Conversely, tax-exempt interest from municipal bonds—ever more appealing to those trying to avoid the Medicare 3.8 percent surtax—will be included in your Medicare MAGI. You may want to temper such investments, particularly if they push you into the next-highest income bracket. Unless the income you gain exceeds the higher Medicare premiums you will pay, you will incur a net loss.
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Planning for Medicare costs is a stepwise process. By looking ahead to plan for two significant such expenses—namely, Medicare Parts B and D premiums—you will have come a long way in planning for your health-care costs in retirement.
—By Katy Votava, special to CNBC.com. Katy Votava is president and founder of health-care consulting firm Goodcare.com. A nurse practitioner with a Ph.D. in health-care economics, Votava is a consultant, speaker, researcher and advocate for retirement health-care planning, working with financial advisors, individuals and small businesses.