Healthcare Before 65: In-Depth ACA vs. Roth Conversion Analysis

Are you retiring before 65? Well, you may face a difficult decision as you try to optimize tax planning alongside your health care prior to 65. In today's video, we're going to shed some light on this complex but important variable. Today's video will be focused on Affordable Care Act Insurance, otherwise known as Public Marketplace Insurance. Now, you may live in a state that has its own health insurance marketplace, like Covered California. Know that these marketplaces largely work just like the ACA marketplace, and so the information in this video will still apply. I first want to give you a high-level look at how exactly ACA insurance works. The website healthcare.gov can give you a deeper look if you're looking to learn a little bit more. When choosing a health care package to use on the marketplace, you effectively have four options ranging from bronze to platinum plans. As you can see with the graphic on the screen, a bronze plan will be a cheaper plan on a per month basis, carrying a lower premium cost, but as a trade-off, covers the least amount of out-of-pocket costs. If you're a healthier retiree that is comfortable self-insuring to some extent, a bronze plan might be right for you. As you scale into silver, gold, and platinum, the plan cost goes up, but so does the coverage. In my anecdotal experience, silver and bronze are the most commonly chosen plans. Now, the most important feature of ACA insurance is that the government will provide you with a subsidy, thus lowering your monthly health insurance costs depending on how much quote-unquote income you show in a given year. Show a low income and you can have health insurance at potentially no monthly cost, but this creates the question, how is your income determined, and what is classified as low income that can earn you a pretty big subsidy? Here's a snapshot of what is included as income that counts towards earning or losing a subsidy. This income number is referred to as Modified Adjusted Gross Income, or MAGI, but know that there are multiple MAGIs in the tax code. For instance, this MAGI is different from the IRMA's MAGI. The biggest differentiator with ACA MAGI is that all Social Security benefits, even untaxed ones, are counted against you in terms of income. Remember, your goal is to keep MAGI low to earn a subsidy. So, a big mistake I see a lot of retirees make is taking Social Security early in retirement, right at 62, thus receiving a permanent cut in benefits. On top of this, this income is counted in their ACA MAGI and can often force them to lose valuable subsidy dollars. It's worth pointing out as well that tax-exempt interest, like muni bond interest, is also added into this MAGI number. So, if you wanted to artificially keep your MAGI low, how can you do this based on this formula? There are two big options that you have. Number one, you can take money from Roth accounts. You could theoretically take a million dollars in a given year in Roth withdrawals and still have a zero dollar MAGI based on this formula. So, Roth can be used as a way to keep that income artificially low. Number two, you can use your taxable account or savings. Say you sell a $100,000 position that has $75,000 of cost basis. You will have $25,000 of capital gains then. Well, just this $25,000 will count towards your MAGI. The other $75,000 can be taken for income without counting at all towards MAGI. The next question then, how much income can you have and still earn sizable health care subsidies? This is a more complex question because it depends on when you will be on ACA insurance. This is mainly because expansion from the Inflation Reduction Act is ending at the end of 2025. So, ACA looks significantly different in 2025 than beyond 2025. Here's what stays the same in both scenarios. The subsidy you earn is based on percentages of the federal poverty level. On the left-hand side of the screen, I have federal poverty levels shown for households up to eight people. Once you are over 150% of the federal poverty level for your household level, you will start to lose portions of your subsidy. Those portions for 2025 will coincide with the percentages on the right. You can see how these percentages scale as you show higher and higher levels of income. Let's just use an example here to be clear. 400% of the federal poverty level is $81,760 for a couple. Once you reach this point and above, your family's contribution towards a benchmark plan will be required to be eight and a half percent of your total income. In layman's terms, the higher your income, the more you will pay for health care. Now, this is where we enter into some complexity. I'll try to be a bit slower in my explanation here to increase understanding. Subsidies in 2025 and beyond will still be based on percentages of the federal poverty level, but how much you are forced to contribute to your health care plan will change from this year to the next. The contribution percentage I just showed are only for 2025. Come 2026, we will revert back to the much less forgiving levels. Right now, you can show more than 400% of the federal poverty level and still earn a subsidy, albeit a smaller one. For instance, you might still be able to earn a $900 per month subsidy at an income level of $85,000. At $120,000 of income, your subsidy will fall somewhat linearly, but you still might earn a subsidy of say $700 per month. Show $150,000 of income, again, you will still earn a subsidy, but it will be less. The point being, you can show higher income in 2025 and still earn a lot of health care cost relief. Come 2026, as the rules stand today, this linear phase out of subsidies is discontinued and something referred to as the subsidy cliff comes back. This subsidy cliff is set at 400% of the federal poverty level. Once you hit that point, your subsidy phases out swiftly. For example, you might earn a $600 per month subsidy prior to this, and then a few dollars over this cliff and poof, it's gone completely. Notice as well on the graph, the subsidy phase out prior to that 400% poverty level happens quicker than the current system as well. Again, in layman's terms, earning health care subsidies becomes more difficult after 2025. Here's a Each state varies quite a bit, but as you can see, average annual premiums will rise by at least 80% for those currently receiving a subsidy when this shift occurs. If you're going to be on ACA insurance post 2025, this shift is something you must be planning for. Insurance prior to 65 is one of the clearest areas a retiree can use to improve their position in retirement. Again, we are talking about if you manage this situation correctly. Here's a snapshot showing this point with more exact numbers. Here we are comparing the same gold plan for a Texas resident. If this retiree would report $50,000 of income for their Maggie, they would be paying a bit less than $400 per month for gold plan insurance. If we assume medium use for medical services, total estimates for the yearly costs for this couple would be about $5,300. Let's compare this to mostly unsubsidized insurance. This couple would need to show over $200,000 of income in 2025 to hit this point. At this point, their health care premium would be almost $2,100 per month. Add in medium use of medical services and total yearly costs almost total $26,000 and over $20,000 difference in total costs. The good news here is in 2025, you would have to show some pretty high income to see this big of a subsidy phase out. The bad news in 2026 and beyond, this phase out will happen at much more modest levels in the $80,000 range for a household of two. Again, hopefully it's clear that with this comparison, health care planning is one of the biggest levers you can pull to improve your position in retirement, especially in early retirement. But now that we have a basic understanding of how the public marketplace and subsidies work, let's talk about how to factor this variable into your tax and Roth conversion planning. The information to come will help inform both Roth conversions as well as withdrawal order from your accounts. Those of you that regularly watch this channel have seen me go over this example before and unfortunately are probably going to need to watch me go over it about another hundred times. When deciding if a Roth conversion makes sense or not, you need to compare the marginal tax rate you pay on a Roth conversion today versus the marginal tax rate you would otherwise pay if you withdrew those same dollars out from a pre-tax account in the future, given no Roth conversion. If the growth rate is the same, which we would assume it is, then the math solely comes down to tax rates. For instance, if you could pay a 22% tax rate on a Roth conversion today to avoid taking money out in the 24% bracket in the future, you come out ahead with a Roth conversion today. If you would have to pay a higher rate, like 32% today on said Roth conversion, a Roth conversion in this case would be destructive to your wealth because you're paying a 32% rate to avoid 24%. On the screen I have proof of this general concept where I equalize out the tax rate today and the tax rate you would otherwise pay in the future and voila, you end up with the same amount of wealth after taxes in both situations. So again, Roth conversion math comes down to tax rates. So then step number one of really tax planning in general but also specifically planning around ACA insurance is to analyze your forward tax plan. A forward-looking tax plan is a process in which you project out growth and withdrawals from your accounts in the future in order to see what tax problems lay ahead. For example, eventually you will be forced to withdraw money from your pre-tax account in the form of something called required minimum distributions or RMDs. These RMDs, if large enough, can force you into higher tax brackets and other tax hurdles. Now I generally like to look at a forward-looking tax plan in a bad, average, and great scenario to see what tax problems arise in varying performance environments rather than just staking all of our planning on just one scenario. But the example graph on the screen shows a situation where this retired couple will certainly have future tax problems that can help be avoided through Roth conversions. You can see that they continually rise in the given marginal tax bracket they are in because of these forces like RMDs. Now Roth accounts don't have RMDs, so converting from pre-tax to Roth can help alleviate tax problems in a big way. Throughout this process, we are trying to gain more insight into what tax rate targets we are comfortable converting below. For example, if we're going to have RMDs push us up into paying tax rates in the 30% range, then if we can convert today at rates lower than this, we gain a benefit from that Roth conversion. So let's jump into looking at ACA specifically in the context of Roth conversion planning and tax rates. So let's jump into looking at ACA specifically in the context of withdrawal order, Roth conversion planning, and tax rates. Here we have a 60-year-old couple in Arizona. The lowest MAGI they can realistically reach and still hit their income goals is $40,000. They do this through a combination of using Roth accounts and their medium-sized taxable account. They need a bit more than $100,000 to live on. So what I'm going to do here is show higher and higher levels of MAGI and show what the overall cost would be in the context of tax rates. We will assume medium use for medical services in these examples. Now one thing that is worth noting that we haven't mentioned yet is that a health care subsidy doesn't just affect your monthly premiums. In general, the higher the subsidy you earn for a given plan, the lower your deductible will be, which also means you have a lower out-of-pocket cost if you incur those out-of-pocket costs. Now at a $40,000 MAGI level, this couple can find a silver plan that only costs them about $100 per month, and this covers the doctors they regularly use. Now as we dive into this analysis, we're going to be using this table right here. In blue, you will notice us increasing the income levels with each given row. In red, you will see the ACA-specific numbers. We show the monthly subsidy at each level, the net premium for the plan on an annual basis, the plan deductible, and an estimate of total costs assuming medium use of medical services. In yellow then, we have marginal cost numbers. Behind the scenes, I'm calculating the marginal tax costs so they are clear for you. Next, I'm showing the marginal cost for ACA. For example, from row one to row two, we are increasing MAGI by $10,000. This couple would owe $3,300 more in estimated health care costs based on that $10,000 increase. As you can see in row two, this means the marginal cost of ACA is 33%. Then in orange, I include the summary tax rate stats for easier calculations. Why is this calculation process important? Well, if we decide to raise our MAGI, either because of a Roth conversion or withdrawing from a fully counted source like a pre-tax IRA, we need to know what marginal tax rate we are paying. As you will see, marginal costs can vary quite widely, which can have different implications depending on your situation. Pause the video if you need to compare variables row by row, but what we care most about in the context of tax planning is the rightmost orange column. Marginal tax rate is most important here, but I included effective tax rate because it can help in certain situations. Take the first two rows, someone going from a MAGI of $40,000 to $50,000. Many retirees wouldn't bat an eye at this MAGI increase. Taxable income is still very low, which means the tax rate you are paying on withdrawals will also be quite low, only 12.5% as you can see. But the marginal cost increase to ACA is quite significant. Taking that extra $10,000 of income means you are giving away nearly $5,000 of that withdrawal to taxes and extra health care costs. Following this table down to higher and higher MAGI levels, and you will see marginal costs vary level by level, often in quite unexpected ways. Going to the next slide, I've highlighted in red areas where we see some big changes in marginal rates. Notice they happen at some of the lower levels of MAGI. In green, I've highlighted areas that are relatively stable in There is a common adage that taxes will go down when you retire. As you can see, marginal tax rates can often be quite high in retirement. Let's say this couple isn't yet retired and has $0 in Roth accounts. Say their working income puts them in the 24% federal tax bracket. This would actually be a 26.5% marginal rate after factoring in Arizona taxes. Despite being in a relatively high bracket, this couple would see a lot of reasons to Roth convert even while working. Roth dollars become extremely valuable during those ACA planning years, because they can help keep that MAGI lower. If this couple could use Roth dollars to lower their MAGI from $80,000 to $40,000, they would avoid marginal tax increases in the 30% to 45% range. Going back to the Roth conversion example before, they should 100% do this. Pay 26.5% to avoid 30% plus in tax rates is a no-brainer. So, there is some clear practical use with this table. This table can be used in the same way post-2025, but the numbers will obviously change drastically based on the changing subsidy system. But given the numbers we see today, how should this couple handle Roth conversions, withdrawals, and setting their MAGI level? Well, it's quite different depending on their forward-looking tax plan. Context here matters. It's important to know how to build out a tool like this table, but even more important to know what to do with this tool contextually. Let's say we look at this couple's forward-looking tax plan, and they don't have major tax problems down the road. We then probably want to earn the biggest subsidy we can and peg them at the MAGI level highlighted in green. This person will still have the opportunity to Roth convert once on Medicare, so we don't need to cost ourselves greatly right now. Then highlighted in orange, I have a zone where it would be difficult to make a case in ending their MAGI here. For instance, say they do a $20,000 conversion or take $20,000 more from their traditional IRAs to end up at a $60,000 level. What could be the reasoning for doing that? They pay some big marginal cost to get there and don't really receive any benefit for doing so. Then in red, let's say this couple has some major tax problems like the forward-looking tax graph I showed before. They may not have enough time to deal with all of their tax problems once on Medicare. The area in red would be an area that makes prudent sense to convert or withdraw up to. Their marginal cost remain low for a period of time, and their effective tax rate is still within a zone this couple should be comfortable with. Now, I stopped this table at $130,000, but we can see that at a minimum, their marginal cost for going higher would be above 33% because they owe 24.5% or more from a tax perspective and a minimum of 8.5% from an ACA perspective. If you're looking to create a table like this for your situation, you can do so by using healthcare.gov to compare plan prices at varying levels of Maggie. Then all we need is the ability to accurately project out taxes and tax rates. But as you can see, this is a very important tool to have at your disposal to make clear decisions. Now, I want to share a couple things to keep in mind in this process. Number one, know that the numbers in this table will change quite a bit when we look at a 2026 table of these numbers because big changes are coming to ACA. You will see a tax cliff where major costs are associated with the cliff at 400% of the federal poverty level. Number two, based on the state you reside in, the numbers can change quite a bit. For instance, here is a graph showing the impact of the subsidy cliff in varying states. The subsidy cliff will be quite a bit more expensive for someone in, say, West Virginia than someone in Maryland. This is why it's important to build out this table specifically for your state and situation. Then finally, number three, you have quite a bit of control over your Maggie. You can use Roth and taxable account assets to keep a high income to live off of, but then report a very low income for the sake of ACA purposes. This is a classic example of you don't need more money, you need a better plan. If you like this video, know that healthcare planning doesn't just stop once you've reached age 65. Once 65, you go from worrying about ACA to now having to navigate Medicare, which carries its own set of complexities and surprises. Click here to learn how to navigate Medicare and tax planning next. Always remember, you don't need more money, you need a better plan. Look forward to seeing you in the next video.