The Medicare Files: Program Basics

Let’s start this series on Medicare at ground zero and build up from there.

Medicare is a federal health insurance program that was established in the 1960s for individuals age 65 or older and for individuals under age 65 with kidney failure, ALS or certain other disabilities. It is funded by the taxes that workers pay to Social Security and Medicare, by the premiums that Medicare beneficiaries pay for their coverage, and by the federal budget.

Medicare has four parts: A, B, C and D. Part A and Part B are considered Original Medicare as they are provided directly through the federal government and Part C and Part D are not considered Original Medicare as they are not provided directly by the federal government.

Part A covers hospital insurance. This includes inpatient hospital care, skilled nursing, hospice care and home health services. This does not include long-term care. You don’t have to pay a premium for Part A coverage as long as you, your spouse, or your ex-spouse worked full time for at least 40 calendar quarters (10 years) and paid Social Security taxes, or if you, your spouse, or your ex-spouse are eligible for Railroad Retirement or Civil Service benefits. You do have to pay a premium if you worked and paid Social Security taxes for less time. If you qualify through your spouse or ex-spouse, you need to have been married for at least 10 years. Most Medicare beneficiaries qualify for this premium-free coverage.

Part B covers medical insurance. This includes outpatient medical care such as doctor visits, tests, preventative care, mental health care, medical equipment like wheelchairs and walkers, and some ambulance and home health services. You have to pay a premium for Part B coverage to the Social Security Administration. If you’re already receiving Social Security, the premiums are deducted from your Social Security benefit, otherwise Social Security bills you directly. The premium starts at a standard amount and increases for people with higher incomes. Each year the premium increases but current Medicare beneficiaries whose premiums are deducted from their Social Security benefit generally avoid the increase due to a hold harmless provision.

Part C is something of a misnomer as it doesn’t refer to a subsection of medical care like the other Parts. Instead, Part C refers to Medicare Advantage Plans, which are plans offered by private companies that have contracted with Medicare. Medicare Advantage Plans are required to provide all Part A and Part B benefits, but can do so with different rules, costs and restrictions. For example, with Medicare you can go to almost any hospital or doctor’s office whereas with Medicare Advantage Plans you can be limited to network providers. Many Medicare Advantage Plans replace Part A, Part B, Part D and Medigap coverages (more on Part D and Medigap below), as well as offering coverage for vision, dental and hearing services. You pay an additional premium for these plans on top of your Part B premium (and your Part A premium if you have one).

Part D covers prescription drugs and is offered by private companies. You can get Part D as a stand-alone private drug plan (known as a PDP) or as a part of a Medicare Advantage Plan with drug coverage (known as a MAPD). However, neither Medicare nor Medicare Advantage Plans cover prescription drug copayments or deductibles. As with Part B, the premium increases for people with higher incomes.

Medigap is supplemental insurance coverage offered by private companies that is designed to fill the gaps in expenses not covered by Medicare. Medigap covers Part A and Part B copayments, coinsurances and deductibles.

Depending on if you are employed or retired, there are different timelines for enrolling in Part A and Part B. However, once you are enrolled in Part A and Part B, there are several paths to getting enough coverage to address your long-term medical needs. If you just enroll in Part A and Part B, you would likely incur substantial out-of-pocket costs. To avoid this, you can enroll in Part A and Part B and supplement these benefits with Part D and/or Medigap coverages. Or if you have employer, retiree, or Veterans’ Administration (VA) medical benefits available to you, these programs can help defray costs. Or you can follow in the footsteps of 1/3 of Medicare beneficiaries and get your benefits through a Medicare Advantage Plan.

Killing Me Softly with Jargon: RMDs

Another day, another acronym. The financial industry is rife with them, causing cringes, confusion, and avoidance, so I try to assume the mantle of translator from time to time. RMD is an important term to know, particularly if you’re approaching retirement, or if you’re already in the thick of it. RMD stands for Required Minimum Distribution, and it is the amount that the IRS requires you to withdraw from your tax-deferred retirement accounts when you turn 70 ½. Tax-deferred retirement accounts include qualified defined contribution plans (401(k)s, 403(b)s, 457s, and Thrift Savings Plans), as well as the basket of IRAs (Traditional, Rollover, SEP, and Simple). (There is one conspicuous exception in the lineup here – RMDs are not required for Roth IRAs since they are funded with after-tax money and therefore are not tax-deferred.) The catch here is that the RMD is tax-deferred money, so you will be liable for taxes on it at ordinary income rates.

There are two options for when you can take your first RMD. The first option is to take it anytime in the year that you turn 70 ½. The second option is to take it by April 1 of the year after you turn 70 ½. Initially, the second option seems like a boon, as it delays the administrative work and the tax hit into the following year. However, doing this can cause a much higher tax bill the following year, as you will also need to take your second RMD that same year. The result could even push you into a higher tax bracket, which should be avoided if possible.

A common question is, what happens if I have a motley crew of retirement accounts, do I have to take a separate RMD for each account? Well, you can combine all your IRA account balances and take one RMD from one of the IRAs, and combine all your 403(b) account balances and take one RMD from one of the 403(b)s, but if you have another kind of qualified defined contribution plan like a 401(k), you have to take the 401(k) RMD from that account only. So the answer is yes, aggregation is possible, but it depends on the account type.

If you’re still working at age 70 ½, your qualified defined contribution plan may allow you to defer taking your RMD until you actually retire, so it is worth checking with your plan administrator about this. It is generally prudent to continue realizing the benefits of tax-deferred compounding until you have to stop. If you’re still working at age 70 ½ and own more than 5% of the business, you can’t defer taking your RMD until retirement. Furthermore, your ownership can be attributed to your spouse and/or children also employed by that same business, and can prevent them from deferring their RMDs until retirement as well.

If for some reason (including but not limited to the cringes, confusion, and avoidance mentioned above) you missed the deadline to take an RMD, the IRA penalty is particularly harsh – 50% of the amount that you owe for the RMD. For example, if your RMD is $5,000, you would owe the IRS a hefty $2,500 (plus the tax you owe on the RMD itself). Of course, this money would be much better spent on… almost anything else.

How are RMDs calculated? Turns out it’s not an onerous process of sifting through IRS tables or identifying correct distribution factors, as the Internet is benevolent. I like Charles Schwab’s online RMD Calculator, which is simple and user-friendly. All you have to do is input your account balance as of 12/31 of the previous year, your date of birth, your primary beneficiary and their date of birth, and the rate of return you expect to receive on the account, and ta-da your RMD is calculated. The last thing to note here is that you are not limited to the RMD amount at any time – you can take out as much as you want, even the whole ball of wax. The piper – ahem the IRS – certainly won’t stop you as they are happy to collect the taxes whenever you are ready to pay them.

College Savings Plans: The Magic Number is 529

For a standout option for college savings, look no further than 529 plans. 529 plans are investment accounts with tax-deferred earnings and tax-free withdrawals, as long as they are used for qualified education expenses. 529 plans, also known as “qualified tuition plans,” are sponsored by states, available directly from plans or through advisors, and take their name from Section 529 of the Internal Revenue Code.

There is a second, little-known category of 529 plans called “prepaid tuition plans,” somewhat antiquated plans where you can lock in a tuition rate through the purchase of credits. However, these plans have many limitations and states are beginning to drop them. The first category of 529 plans discussed here have far greater visibility and popularity.

Along with tuition, 529 plans can be used to pay for qualified education expenses including room and board, fees, books, computers and related equipment, and supplies. However, earnings on withdrawals used for non-qualified expenses are subject to federal and state income taxes and a 10% federal penalty tax. 529 plans offer flexibility with choice of schools and can be used at a variety of institutions, including colleges, universities, trade or technical schools, and some foreign schools.

In addition to the benefit of tax-deferred earnings and tax-free withdrawals, some states offer tax deductions or credits for 529 plan contributions. In many cases, if the maximum deduction is met in one year, the deduction can roll over into subsequent years. Almost all states mirror federal law and offer state tax exemptions on withdrawals.

You don’t have to save in your state’s plan. The key is to first look at your state for tax deductions or credits, and if there is one, it usually makes the most sense to claim it. But if you live in a state with no income tax or you don’t have any tax deductions or credits available, by all means shop around with other states’ plans and compare and contrast their performance.

529 plans are very accessible, with investment minimums as low as $10 and high contribution limits. Individuals can apply the $14,000 annual gift tax exclusion to their contribution for one year ($28,000 for couples), or make up to 5 years worth of contributions at once by contributing $70,000, without triggering the gift tax ($140,000 for couples). For high-net-worth folks, this gifting strategy can be used to reduce the size of their taxable estate. Lifetime maximum account values are between $300,000-$400,000 per beneficiary, depending on the state, and a beneficiary can have multiple accounts as long as the total money in all accounts does not exceed the state limit on contributions. Anyone can contribute to 529 plans – grandparents, parents, aunts, uncles, friends, and so on.

The 529 account owner retains full control of the assets throughout the lifetime of the account, including the right to take the money back (although this would be a non-qualified withdrawal and subject to federal and state income taxes and the 10% federal penalty tax). If the original beneficiary gets a full scholarship, ends up with an unused balance, or doesn’t go to college, the account owner can change beneficiaries or transfer assets to another family member, as many times as needed. The IRS’s definition of family member is generous, including step-siblings and first cousins, for example. Account owners can also use the plan for their own educational needs.

To minimize impact on financial aid, it’s generally best for 529 account owners to be the custodial parent(s). Assets in a 529 plan held by a custodial parent count against need-based aid up to a maximum of 5.6%, whereas withdrawals from a 529 plan held by grandparents or non-custodial parents are considered untaxed income to the beneficiary the following year, and could reduce need-based aid by as much as 50%.

529 plans exclusively use mutual funds and offer two investment options. The first is an age-based portfolio option, similar to a target date retirement fund, where the investments shift from aggressive (high percentage of stocks) to conservative (high percentage of bonds and cash) as the beneficiary gets close to college age. The idea is that the portfolio increases the chance of gain early on and reduces the risk of loss later on. The second option is a static portfolio, where the funds stay the same over time, and the account owner rebalances as they see fit, up to once a year. Within both of these options you can still choose your risk tolerance and have a diversified portfolio. 529 plans are undeniably worth it – as JP Morgan Asset Management tracks it, even in its worst 18-year period, a 50/50 mix of stocks and bonds outperformed tuition inflation.

Lastly, a quick note about direct-sold versus advisor-sold plans. Advisor-sold plans have on average a 4.75% commission attached to them, increasing plan cost and cutting into plan returns. According to Morningstar, most 529 plan assets are invested in age-based portfolios, which are automatically rebalanced over time, and account owners tend to stick with this allocation. It makes you wonder, what is the need for an advisor then? In fact, Morningstar’s 2016 ranking of the best 529 plans overwhelmingly puts direct-sold plans at the top of the list.