Reimburse Spouse's Medicare Premiums Tax-free? Only if . . .

Medicare premiums are a qualified expense. But there's a catch that you need to understand - and for which you may need to plan.

Health Savings Accounts are the most tax-efficient means of saving for retiree medical costs. Not only can an account owner reimburse qualified medical, dental, vision, and over-the-counter expenses tax-free, but the list of qualified expenses expands at age 65 and beyond to include Medicare premiums.

Medicare premiums are no laughing matter. Despite the perception among younger Americans that they prepay their Medicare premiums through payroll taxes during their working years, Medicare coverage isn't free. The standard monthly premium for outpatient coverage (Medicare Part B) is $148.50, or about $1,800 annually. (Note: Depending in income, it can be higher.) Add prescription-drug coverage (Medicare Part D) and the bill can top $2,500 per year.

Paying Premiums through a Traditional Retirement Account

If you're age 65 or older, enrolled in Medicare, and working, paying $2,500 annually for Part B and Part D may not be a burden - particularly if you're enrolled in Medicare rather than your company's group coverage. In fact, Medicare premiums may be lower than your coworkers' payroll deductions for an employer-sponsored plan.

If you're a retiree living on a lower income, premiums may constitute a financial strain. The average annual Social Security benefit in 2020 was $18,000. Paying $2,500 in Medicare premiums represents about 14% of the total Social Security benefit.

But most people have saved some money (though many far too little) to pay living costs in retirement. Most retirement funds are placed in a traditional 401(k) plan or Individual Retirement Account. Contributions to these accounts aren't included in taxable income. And taxes on the growth of the balance through investments is tax-deferred. But owners pay the tax piper when they withdraw funds in retirement, as distributions are included in taxable income.

A typical owner of a traditional IRA will have to withdraw about $3,125 annually from her account to pay $2,500 in Medicare premiums. That figure assumes a combined 20% federal and state income tax rate. Bump the tax rate to 25% and the withdrawal increases to $3,333.

Paying Premiums through a Health Savings Account

Health Savings Accounts enjoy superior tax treatment to traditional 401(k) plans and IRAs. Contributions aren't included in taxable income, nor are they subject to federal payroll taxes (as traditional plan contributions are). Health Savings Account balances grow tax-deferred as well.

The big difference is in the tax treatment of distributions. Distributions for qualified expenses are tax-free. Thus, in the case of our $2,500 Medicare premiums, a Health Savings Account owner must withdraw only $2,500 - not $3,125 or $3,333 - to pay the full premium.

That difference adds up. Assuming 3% annual premium increases, the difference over 20 years is about $16,800. For a retiree living on a fixed oncome substantially lower than her pre-retirement income, that's a substantial difference.

The Quirk in the Rule

Health Savings Account owners can pay not only their own, but also their spouse's Medicare premiums. Thus, all figures above are doubled for a couple.

But there is one caveat in the rule. An account owner can't reimburse a spouse's qualified Medicare premiums until the account owner himself is age 65 or older.

Example: Tatiana retires at age 66 and enrolls in Medicare. Her husband, Big Jim, is age 63 and has accumulated a substantial balance in his Health Savings Account. Big Jim can reimburse Tatiana's Medicare cost-sharing (deductibles, coinsurance, and copays), her unreimbursed dental expenses, and her over-the-counter medicines with tax-free withdrawals from his Health Savings Account. But he can't reimburse her Medicare premiums tax-free until he turns age 65. [And, to anticipate another question, no, he can't wait until he's age 65 and reimburse Tatiana's past Medicare premiums retrospectively.]

Planning

In cases in which the younger spouse owns the Health Savings Account, a couple must plan. Their goal: To build sufficient balances in a Health Savings Account owned by the older spouse to cover the older spouse's Medicare premiums until the younger spouse with the higher account balance turns age 65.

Not all couples can achieve this goal. The older spouse may be a veteran who carries TRICARE (the federal insurance program for active and retired military personnel) and thus is disqualified from opening and funding a Health Savings Account. But in many cases, both spouses are eligible to open and fund an account.

So, here's what they should do: Beginning at age 55, the older spouse, if she's HSA-eligible, can open her own account and make a $1,000 catch-up contribution. It's easy to identify a fee-free Health Savings Account and to make an annual or recurring contribution. If she does that for 10 years and earns a 4% annual return, she'll have a balance of $12,250 in her account when she turns age 65. That amount will cover four or five years of her Medicare Part B and Part D premiums.

If the spouses' age gap is greater than the amount that a $1,000 annual catch-up contribution can cover, there's a way to place more money in the older spouse's account. Simply split the couple's regular contribution ($7,200 for family coverage in 2021) between the two accounts, rather than placing it all in the younger spouse's account through pre-tax payroll contributions. For example, limit the younger spouse's pre-tax payroll deductions by $1,500 annually and increase contributions to the older spouse's account by that amount. That'll increase the older spouse's account value after 10 years to $30,600, which will cover nine or 10 years of inflation-adjusted Medicare premiums.

What's the cost of diverting contributions from pre-tax payroll deductions to personal contributions? Not much. The contributions to the spouse's Health Savings Account are tax-deductible, so the couple recoups federal and state income taxes (except taxable income in California and New Jersey). They end up paying the FICA payroll taxes (7.65% for most wage earners) when they make personal contributions. Still, that's a price of $114.75 ($1,500 times the 7.65% payroll tax) of additional payroll taxes to pay Medicare premiums with tax-free distributions from a retirement account.

That seems like a reasonable price to pay.

The Bottom Line

Understand your situation. Learn the rules. Always take advantage of the tax benefits of having a spouse make tax-deductible catch-up contributions to a Health Savings Account if he or she is eligible. And make sure both accounts are sufficiently funded to reimburse all qualified expenses tax-free.

I'm director of strategy and compliance at Benefit Strategies, LLC, a provider of Health Savings Accounts and other tax-advantaged benefits. You can read my biweekly Health Savings Account GPS blog and subscribe by clicking here and my weekly HSA Monday Mythbuster and HSA Wednesday Wisdom columns, as well as my occasional Healthcare Update column, on LinkedIn. My book, HSAs: The Tax-Perfect Retirement Account, is the definitive guide to navigating the intersection of Health Savings Accounts, Medicare, and retirement planning. It's available in book and e-book forms from Amazon.

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