Early Retirement Health Insurance Strategy: Cash Withdrawals vs. Roth Conversions for PTC Optimization
I recently met with someone under 65 who was interested in sourcing their yearly income from their cash account during their early years of retirement to ensure they continue to receive the premium tax credit (PTC) which reduced their out-of-pocket health insurance premiums.
Their thought process was minimizing their taxable income down to near $0 so the PTC amount would be close to 100% of the premium dollars.
This sounds great but there’s some additional items to consider:
Is taking from cash the best? Are there other accounts you should/could be pulling from? How much of your total cash will be depleted? Over how many years can you keep this up? At what future opportunity cost?
Is keeping your income near $0 the best tax decision? Would using Roth conversions be the better long-term financial decision?
Before we dive into evaluating these considerations, let’s take a step back for context regarding the PTC.
After 65, you’re eligible for Medicare and you can choose a plan that works best for you.
If you retire before age 65, you’re on your own for health insurance.
If you can retire early, some individuals will try to retire within 18 months of their 65th birthday so they can use COBRA (extension of their existing group coverage) until they’re eligible to enroll in Medicare - which wouldn’t be eligible for PTC.
For those not on COBRA looking for health insurance, the most common way is through the healthcare exchange.
This is where the premium tax credit (PTC) comes in.
In 2010, the Affordable Care Act (ACA) was passed into legislation which kicked the PTC into effect starting in 2014.
If your income is within 400% of the federal poverty guideline based on family size (subject to a 8.5% of MAGI cap) you can qualify for this subsidy.
The PTC is a federal subsidy that helps individuals and families pay for health insurance purchased through the health insurance marketplace.
Now back to the article…
Using rates from Delaware’s healthcare exchange, health insurance for an age 60 couple age on a bronze plan is $2,077/mo.
Meaning if someone had income 100% or less of the federal poverty guideline based on family size, they could have the full amount of the premium subsidized.
As income continues to grow, that subsidy amount gets pulled back.
As income continues to grow, that subsidy amount gets pulled back.
So what this means is that even if your income is $250,000 a year as a married couple, you’d still have access to some PTC.
The 8.5% of MAGI cap was enacted in 2021 and was extended through the end of 2025.
Prior to this ruling the 400% of federal poverty line was a cliff and many individuals, if even only a dollar of income greater than the 400% federal poverty guideline cap, would be ineligible for any PTC benefit.
Circling back to our example above of someone using cash to ensure 100% of their PTC is subsidized - this ignores a couple things (of which, I’m sure you’re sniffed a few by this time):
Using 100% cash ignores that there’s still room between $0 income and 100% of the federal poverty guideline to take advantage of.
The PTC isn’t all or nothing, so above 100% to 8.5% MAGI cap, there's the ability to qualify for some PTC.
By not using the 10% or 12% federal tax brackets, you’re missing an opportunity to pay taxes at those rates (opposed to potentially & likely higher rates down the road).
Great tax planning is about levelizing your tax bill over your lifetime.
Roth conversions today may reduce future required minimum distributions, Medicare IRMAA, and taxes on social security.
After required minimum distribution (RMD) age, the Roth conversion window dramatically falls off in terms of benefit - which increases its value between retirement age and RMD age.
What other accounts are available to be pulled from outside of cash? Do they have taxable, tax-deferred, and Roth assets? What’s the percentage of funds available in each tax classification?
All of which to say that whether this decision to attempt to reduce income to benefit from the PTC isn’t an all or nothing decision - its benefit operates on a glide path over time.
Through financial planning modeling software, I dug into what this might look like for either scenario and I could see this actually in favor of reducing income or accelerating income for Roth conversions.
The below scenario reduced living expenses for the 5-year period between 60-65 to account for the reduction in health insurance premiums - assuming that all $2,077/mo were covered by the PTC.
This $24,924/yr savings over the 5-year period allows the otherwise unspent portfolio assets to accumulate throughout the life of this individual.
$518,424 in lifetime value.
Contrast this by implementing an annual Roth conversion over a 5-year term at $50,000/yr.
$646,956 in lifetime value.
This isn’t to say that one scenario is better than other - because it’s the assumptions that underlie the plan that cause this to be more favorable.
Taxes, growth rates, inflation, how much money is converted, and death are all variables in the plan that could change the outcome.
So what should you make of all of this?
The decision to reduce income to maximize the PTC isn’t black and white - the answer lives in the gray space between your personal situation/preferences and trades offs you’re willing to make.
Leveraging the PTC by keeping income low and generate sizeable short-term savings - but ignoring Roth conversions during low-income years can be a ticket to increasing your lifetime tax bill.
Instead of asking, “how can I keep my income as low as possible to increase my PTC benefit?”
Ask, “how much income can I recognize each year while still optimizing tax brackets, managing future RMDs, and while preserving access to the PTC?”
A well-crafted strategy isn’t about reducing your expenses or tax bill in the short term, rather, building a tax-efficient plan to reduce your lifetime tax bill.