In a recent post, I discussed some of the tremendous tax advantages associated with early retirement. This follow-up discusses another aspect of the tax code that is very favorable to early retirees: ACA subsidies.
It’s often a low-cost lifestyle that enables people to retire early and benefit from low taxes in retirement. Well, this also makes them prime candidates for Affordable Care Act (ACA) -- also known as Obamacare -- subsidies.
This post was planned before the election; since then, of course, Donald Trump has been elected President. This has a potential impact on everything I am covering in this article today.
President-elect Trump’s first stated priority (in regards to healthcare reform) is to completely repeal Obamacare. Which campaign promises he will follow through with, and how effective he will be in accomplishing his goals, is an unknown. Therefore, we will focus today on the law as currently written and as is still in effect. I will certainly watch with great interest and plan to write an update regarding any potential changes.
What Are ACA Subsidies and Who Qualifies?
There are two different types of ACA subsidies, each working in different ways to control healthcare costs for low-to-middle income families.
The first type of subsidy, the premium tax credit, limits the amount that households pay on insurance premiums. The second type of subsidy, reserved for those with very low incomes, is cost-sharing reductions that limit out-of-pocket healthcare expenses. This impacts things like deductibles, copayments, or coinsurance.
Note that both subsidies are based on annual household income. No consideration is given to assets. Therefore, early retirees with low recognized income can benefit from both of these subsidies, regardless of how much wealth they have accumulated.
Aside from income, other factors determine who qualifies for ACA subsidies. Full eligibility requirements can be found here.
The Numbers That Determine Qualification
There are two key numbers related to income that you need to know, in order to determine if you will qualify for subsidies under the ACA. The first is your household income, quantified in the law by your Modified Adjusted Gross Income (MAGI). The second is the multiple of your MAGI to the Federal Poverty Limit (FPL).
Your MAGI includes earned income. It also includes taxable interest, pension, annuity, IRA distributions, Social Security benefits, ordinary dividends, and rental real estate income. MAGI does not include basis on taxable investments, withdrawals from Roth IRAs, or cash taken from savings.
As explained in a previous article on the tax advantages of early retirement, early retirees are in a unique position. They have great control over how they recognize their income. This is achieved by utilizing a variety of combinations of retirement and taxable accounts to limit their income tax burden.
These same strategies can be used to keep MAGI low to maximize ACA subsidies. Thus, limiting health care costs.
The 2016 FPL numbers used to determine 2017 ACA subsidies are as follows:
- $11,880 for individuals
- $16,020 for a family of 2
- $20,160 for a family of 3
- $24,300 for a family of 4
- $28,440 for a family of 5
- $32,580 for a family of 6
- $36,730 for a family of 7
- $40,890 for a family of 8
As long as your MAGI is between 100% and 400% of the FPL for a given household size, you will qualify for health insurance subsidies under the ACA. If you live in states that expanded Medicaid, and you make less than 138% of the FPL, you qualify for Medicaid based only on your income. (Medicaid is a combined state and federal program to assist those with very low incomes and resources.)
In states without Medicaid expansion, an individual with a MAGI between 100 and 400% FPL ($11,880 - $47,520), or a family of 4 with a MAGI between 100 and 400% FPL ($24,300 - $97,200), will qualify for subsidies under the law. In states that expanded Medicaid, the lower limit to obtain subsidies would be $16,394.40 (138% FPL) for individuals or $33,534 (138% FPL) for a household of four respectively. The upper limits are the same regardless of where you live.
Subsidy Cliffs and the Premium Tax Credit
The early retirement blog, Root of Good, offers further explanation of the lower end (<100% FPL) and upper end (>400% FPL) subsidy cliffs. Having MAGI fall under or go over these cliffs could have dramatic effects on health care choices at the lower end and costs on either end.
This concept of cliffs is very important. It can also be difficult, as your 2017 subsidy is based on what you will earn in 2017, not what you have earned in 2016. Care must therefore be taken to estimate future earnings with accuracy and monitor earnings closely for those near these cliffs.
On the lower end, you would most likely want to ensure that your MAGI is at least 100-138% of the FPL, depending on your state of residence. Not doing so could have two negative consequences. Either of these problems should be relatively easy to avoid for early retirees by either earning a small amount of income or doing Roth IRA conversions to increase MAGI.
The more obvious is that having a very low MAGI would push you into Medicaid. This is undesirable for most adults who can afford private insurance because many providers do not accept Medicaid patients. This effectively limits your choice of health care providers.
There is also a less obvious reason to be careful about keeping MAGI above the lower-end cliff. Imagine a scenario where you enroll in a plan at the beginning of the year expecting it to be subsidized. However, by year’s end, MAGI does not meet the minimum requirements to receive a subsidy. You would be on the hook for the full cost of the insurance plan purchased. You can not retroactively enroll in Medicaid, even though the very low income would have qualified you for it.
On the upper end, the cliff is a bit more intuitive. If your MAGI exceeds 400% of the FPL, you no longer qualify for any subsidies. As long as you are under the upper limit for receiving ACA subsidies, you are guaranteed to not pay greater than 9.69% of your MAGI in medical insurance premiums. The Premium Tax Credit would cover any dollar amount greater than this cap.
Going over the cliff could have major consequences, especially for those living in states with high health insurance costs. Because the Premium Tax Credit is completely phased out for those with MAGI over 400% of FPL, there is no limit on the upper end that they could pay for health insurance premiums. Therefore, making only $1 too much -- and losing the tax credit -- could effectively cost thousands of dollars in excess health insurance premiums.
Using the Premium Tax Credit to Limit Insurance Premiums
As long as MAGI is kept between the upper and lower limits, the Premium Tax Credit can be utilized for two purposes.
By at least keeping MAGI under 400% of FPL, a household can limit the maximum that they will pay for health insurance premiums. By keeping MAGI as close to the lower end limit of 100-138% of FPL, an early retiree can optimize the credit and minimize the amount that they pay for medical insurance premiums. The chart below, taken from The Kaiser Family Foundation, shows the maximum percentage of a person’s income that a person will be required to pay, based on what their income is as a multiple of FPL. Any amount over the cap would be covered by the Premium Tax Credit.
Using Cost Sharing Reductions to Minimize Health Care Expenses
The second ACA subsidy is the Cost Sharing Reduction subsidy. This is reserved for those with lower incomes, ranging from 100-250% of FPL. To qualify for this subsidy, a household must be enrolled in a Silver level plan.
The Cost Sharing Subsidy provides a discount to help low-income households pay for deductibles, copayments, and coinsurance. Normally, Silver level plans pay 70% of health expenses, with the other 30% of costs covered by the enrollee. This subsidy can lower the amount paid by the individual to as low as 6% of costs, with the subsidy covering up to the other 24%. That can offer substantial savings -- up to 80% of out-of-pocket expenses -- for those with the lowest incomes.
The following chart, also taken from the Kaiser Family Foundation, shows the effects of the Cost Sharing Reduction subsidy on increasing actuarial value and the actual dollar limits on annual out-of-pocket expenses for those that receive it.
For those with MAGI between 100-200% FPL, this subsidy can be large. For those with MAGI between 200-250%, the benefit is less valuable, before phasing out completely for those with MAGI >250% FPL.
Putting It All Together
The American tax code is very favorable to early retirees. The ACA is an expansion of the tax code, which also benefits early retirees with low incomes. Early retirees can use their unusual situations to pay lower taxes during their careers and in retirement. Likewise, they can use the ACA to their advantage by utilizing subsidies provided to limit health care costs, until they become eligible for Medicare.
In a worst-case scenario, early retirees can limit their recognized income (defined by MAGI) to 400% FPL. That will cap the amount they can be required to pay for health insurance premiums.
This alone is a huge benefit for those living on a budget, especially since inflation in health care expenses has regularly outpaced the general inflation rate. Without this cap, health care costs can quickly grow to a disproportionate level of an early retiree’s budget, or wipe out their savings.
Are you an early retiree looking to optimize the law to pay minimal health care expenses? Well, this can be accomplished by keeping MAGI to between 100-250% FPL. This qualifies a household for both Cost-Sharing Subsidies and a more substantial Premium Tax Credit. Doing so will greatly reduce medical expenses by limiting both health care insurance premiums and out-of-pocket expenses.
It is important to understand that the key factor determining ACA subsidies is income, relative to the poverty level. The ability to take money from savings, Roth IRA accounts, or basis from taxable investments allows for creativity in creating cash flow that allows for spending well above these amounts, without recognizing a high income as captured with MAGI.