Tax Planning Considerations for Social Security and Medicare

Written By: Brian Ellenbecker, CFP®, EA, CPWA®, CIMA®, CLTC®

While Social Security and Medicare are two distinct programs, many people view them in the same bucket. Social Security provides a source of retirement income, while Medicare provides healthcare coverage for retirees.

Most of the time, the planning focus is on optimizing benefits. However, both programs can impact your taxes and may require upfront tax planning attention to ensure you’re not overlooking anything.

Taxation of Social Security

There are several misconceptions regarding the taxation of Social Security. The rules have changed over the years, which is likely a factor in the confusion.

The amount of taxable Social Security benefits varies based on your level of Modified Adjusted Gross Income (MAGI):

1 – For single taxpayers with MAGI below $25,000 ($32,000 for married couples filing jointly), Social Security benefits are tax-free.

2 – Up to 50% of Social Security benefits may be taxable when MAGI is between $25,000 and $34,000 for single filers ($32,000 to $44,000 for married couples filing jointly).

3 – Up to 85% of benefits may be taxable in years that MAGI exceeds $34,000 for single taxpayers and $44,000 for married couples filing jointly.

For purposes of this rule, MAGI is:

1 – Adjusted Gross Income (AGI) as calculated on your tax return (includes all investment income, pensions, retirement account withdrawals, rental income, etc.) after adding back any deductions for student loan interest, tuition and fees,

2 – Plus tax-exempt interest,

3 – Plus half the Social Security benefit.

IRS instruction to Form 1040 contains the Social Security benefits worksheet, which helps you determine what portion of your Social Security benefit is subject to tax.

For Social Security benefits, there is not a lot of planning that can be done to control the taxation itself. Because it’s based on gross income, most deductions will not have an impact. For most people, the only option is to generate less income, which typically is not possible because the income they are taking is forced or they need all their income for living expenses. However, if you are considering voluntarily generating additional income (Roth Conversions, realizing capital gains, etc.), consider how this might impact the taxation of Social Security.

Suppose your income is low enough that more than 15% of your Social Security is tax-free. In that case, you may want to delay realizing that additional income until a later year when more of your Social Security benefit may be taxable.

Tax Planning with Medicare

Medicare offers comprehensive coverage at a reasonable price, providing a solid option for most people. However, there are costs associated with coverage. Premiums increase for Part B (Medical Coverage) and Part D (Prescription Drug Coverage) as your income hits certain levels. The additional premium you pay due to higher income is referred to as the Income-Related Monthly Adjustment Amount (IRMAA).

Once your Modified Adjusted Gross Income (MAGI = Adjusted Gross Income + Tax-exempt Interest) exceeds $103,000 for single filers or $206,000 for joint filers in 2024, the amount you pay for Medicare Parts B & D increases. These income thresholds are adjusted for inflation each year.  Income from two years prior is used to calculate your current year premiums. For example, 2024 income will determine 2026 Medicare premiums.

Because you have to look back two years, IRMAA planning starts in the year you turn age 63.

Medicare Income Planning Strategies

Reducing your income to avoid IRMAA can be trickier than it sounds. In most cases, the only way to reduce your gross income is to avoid taking the income in the first place. If you need that income to meet your expenses, you may not have the option of not taking it.

Fortunately, there are a few strategies some people may have at their disposal that may help control income and avoid paying more in Medicare premiums.

1 – When choosing a source to withdraw funds from, consider a tax-free source if one is available. Tax-free options include withdrawals from a Roth IRA, the withdrawal of basis from the cash value of a life insurance policy, or selling stocks that are at a loss (or can be offset by current or future losses).

2 – Be flexible with spending and/or spread out large withdrawals. Accelerating or deferring expenses and the resulting income you need to fund those expenses into a different tax year where your income is otherwise lower could help you avoid a rise in Medicare premiums.

3 – If a relatively large withdrawal is required to fund an upcoming expense, try to spread it out over multiple tax years. For example, if you intend to buy a car in January, withdraw half the money in December and half in January.

4 – Pay medical expenses with health savings account (HSA) funds. If you have a health savings account from which you’ve been deferring withdrawals, use those funds to pay for qualified medical expenses. If you have medical expenses incurred in past years, you may also take tax-free withdrawals for those. To take a qualified withdrawal for health expenses from a prior year, the HSA must have been in existence when the expense originally occurred and you should have documentation of that expense in case the withdrawal is questioned.

5 – If you are over 70½ and make donations to charity, consider making qualified charitable distributions (QCDs) from your IRA. These distributions do not count as income and can also satisfy your required minimum distribution. Each IRA owner can make a QCD of up to $100,000 per year.

6 – While most deductions do not reduce your AGI, a handful of “above-the-line” deductions do. The most common ones are deductible contributions to an IRA and HSA account. Others include student loan interest, self-employment costs, and school tuition and fees.

7 – While not an income reduction strategy, if you’re already subject to IRMAA, consider filling up that bracket with additional income. You could either save the funds for future expenses or consider other techniques like Roth IRA conversions. However, be careful of other possible negative tax impacts.

Navigating the complexities of Social Security and Medicare requires careful tax planning, especially when it comes to minimizing unnecessary tax burdens and premium increases. With thoughtful strategies, you may be able to optimize your retirement income and healthcare costs. Be sure to work closely with your financial advisor and tax professional to tailor these strategies to your unique situation and long-term goals.