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Mark Miller: Remaking Retirement

How to Plan Ahead for Retirement Healthcare Costs

Healthcare will be one of the largest categories of cost for most retirees.

Big, bigger, biggest.

Those words capture the retirement healthcare challenge. Healthcare will be one of the largest categories of cost for most retirees--and medical inflation is expected to run 2 to 3 times faster than general inflation.

Retirees can cope by tuning up their Medicare coverage, as we discussed in my last column. That can help control spending in retirement. But what about pre-retirees, who still have the opportunity to plan ahead for the healthcare cost challenge?

The numbers do sound daunting. A healthy 65-year-old couple retiring this year can expect to spend $322,000 (today's dollars) on Medicare premiums and dental insurance, according to Healthview Services, a maker of healthcare cost projection software. Add deductibles, copays, hearing, vision, and dental cost sharing, and that figure rises to $404,000.

That certainly will make healthcare one of the largest areas of expense in retirement. And Healthview bases those figures, in part, on its projection that healthcare inflation will rise at a 5.47% annual rate for the foreseeable future. Public policy poses another risk: the federal government could implement reforms to Medicare--such as premium support--that would shift a greater share of the out-of-pocket burden to retirees.

With that background, let's consider planning strategies that can help mitigate retirement healthcare costs: retirement timing, investing, and two tax-advantaged vehicles that can play a role (health savings accounts and Roth IRAs).

Delayed Retirement
At the risk of sounding like a broken record, my favorite approach to hedge healthcare costs is to work a bit longer and delay filing for Social Security.

A delayed filing can boost retirement income significantly. Social Security's primary insurance amount rises by 8% for every 12 months of delay beyond your full retirement age (currently 66) until age 70--a powerful boost to income that can help fund rising healthcare costs. What's more, the annual cost-of-living adjustment helps keep up with inflation, albeit at a slower pace than medical inflation.

And working longer also means more net years of employer-subsidized health insurance (and fewer years of Medicare premiums and out-of-pocket costs). It also provides an opportunity to sock away additional savings in your 401(k), perhaps utilizing catch-up contribution limits.

Ron Mastriovanni, Healthview's CEO, looks at the healthcare cost challenge from the standpoint of income replacement ratios. Financial advisers use income replacement ratios to measure the income needed to maintain lifestyle in retirement; the standard rule of thumb is 75% to 80% of pre-retirement income. But that captures only part of a worker's future healthcare spending needs, since employers typically pick up 75% of those costs.

Income replacement ratio calculations also fail to capture the higher inflation projected for healthcare. But Mastriovanni still recommends using a ratio-based saving plan. Projecting $425,000 in future healthcare costs, a 55-year-old man with life expectancy of 87 (who plans to retire at 65) could meet those expenses by investing $3,000 annually for 10 years, he says. 

"Big numbers scare people, but you can do something about this," he says.

Maria Bruno, senior investment strategist in Vanguard's Investment Strategy Group, suggests thinking about the challenge as part of a multigoal framework for retirement.

"One question is what healthcare will cost in terms of premiums and other out-of-pocket costs," she says. But you might also want to address long-term care risk, she adds.

"Do you want insurance, or do you want to create a bucket of liquid reserves in the event of a long-term care need?" she says. "And how you want to allocate investments in that bucket?"

Long-term care costs also are rising faster than general inflation. Five-year annual growth in the cost of nursing care a private room is 3.5%, according to Genworth's annual cost-of-care survey.

Does healthcare inflation call for higher equity allocations near or in retirement to keep up? Not necessarily, says Bruno, although she notes that retirees have been more aggressive than what the firm uses in its target date glide path design. Vanguard IRA investors have equity exposure of 60% at age 65, and are keeping it at that level throughout retirement. By contrast, Vanguard's target date fund allocation calls for a 50% allocation in equities at age 65, falling gradually bottoming at 30% at age 72.

Some researchers have argued against the traditional wisdom of falling equity allocations during retirement. In fact, Michael Kitces and Wade Pfau found that rising stock allocations during retirement can reduce the probability of plan failure and the magnitude of failure in a portfolio--although their arguments don't hinge specifically on concerns about healthcare costs.

Health Savings Accounts
Some experts think health savings accounts will evolve into a platform for long-term saving to meet retirement healthcare costs.

HSAs are available to workers in high-deductible health insurance plans. The accounts can be used to meet ongoing deductible and other out-of-pocket healthcare costs. This year, plans can have a maximum out-of-pocket cost of $6,550 for individuals and $13,100 for families. Some employers help offset those costs with contributions to the accounts; this year, combined employer-work contributions can be made up to a combined total of $3,400 for individuals and $6,750 for workers with family insurance coverage.

The tax benefits are compelling: Contributions are tax-deductible, investment growth and interest are tax-exempt, and withdrawals spent on qualified medical expenses also are tax-free. (Funds withdrawn for nonmedical expenses are taxed at the account holder's marginal tax rate; if before age 65, the funds are subject to an additional 20% penalty). HSAs don't have required minimum distribution requirements, and they are portable--they are individually owned and not tied to employers.

HSAs have been around only since 2003, and thus far long-term investing has taken a back seat to usage of the accounts to meet current expenses--96% have their funds in cash, according to research by the Employee Benefit Research Institute.

And a recent Morningstar study noted that 10 of the most popular HSA plans offer mediocre and high-cost investment options. And just one of the plans was found to be "compelling for use as a spending vehicle and an investment vehicle," suggesting there is "much room for improvement across the industry."

That finding is especially concerning, says Pat Jarrett, co-founder of HealthSavings Administrators, one of the plans evaluated in the report.

"You want an HSA that adjusts to changes in your situation," he says. "There are times when people can save just a little or not much at all--and other times when they can really save and invest."

He agrees that most HSAs are not structured to be strong as both spending and investing accounts.

"Most of them are offered by banks, and they see them mostly as checking accounts," he says.

Aaron Benway, a certified financial planner,has created a smartphone app called HSA Coach, designed to help educate people about the accounts, manage and document healthcare receipts, and use the account as a long-term investment vehicle.

After age 65, an HSA can be used to pay a variety of qualified medical expenses, including Medicare premiums (with the exception of Medigap premiums) or long-term care premiums. (Details can be found in IRS publication 969.)

The triple tax benefit increases buying power, especially when compared with the benefit of drawing down from a 401(k), which is subject to ordinary income tax on contributions and investment gains. Benway calculates that a worker earning $60,000 would need to save 25% less to meet medical expenses by splitting annual contributions to a 401(k) and HSA.

Another tax consideration for high-income retirees: qualified HSA withdrawals are not reported as income, which means they are not counted in the formula that determines whether you must pay high-income surcharges on Medicare Part B or D premiums.

One caveat: it’s important to navigate carefully the interaction of HSAs and Medicare during the transition period away from workplace insurance. The key issue is that HSAs can only be used alongside qualified high-deductible health insurance plans, and Medicare does not qualify as a high-deductible plan. That means that if a worker or a spouse covered on the employer's plan signs up for Medicare coverage, the worker must stop contributing to the HSA, although withdrawals can continue. (See this article for more about HSAs in retirement.)

Roth IRAs
If you are not eligible for an HSA, investing in a Roth IRA--or doing a Roth conversion--can provide a second-best option.

Much will depend, of course, on the specifics of your tax situation. Roths get the income tax out of the way upfront, allowing tax-free withdrawal of contributions and investment returns down the road. Roths also are not subject to required minimum distributions (during the lifetime of the owner), which means you can preserve assets to meet healthcare expenses.

Bruno cautions that conversions can bring some undesirable "tax surprises." She recommends considering conversions in low-marginal-income tax bracket years, especially in the years before claiming Social Security. A series of small Roth conversions that "fill up" your tax bracket can make good sense. Backdoor Roths offer another option.

Mark Miller is a retirement columnist and author of The Hard Times Guide to Retirement Security: Practical Strategies for Money, Work, and Living. The views expressed in this article do not necessarily reflect the views of