Why Does Medicare Impose Penalties That May Ensnare HSA Owners?

Note: This article has been updated to correct an error in an example.

Seniors who don't enroll in Medicare when they're first eligible around their 65th birthday may face penalties (premium surcharges) when they finally sign up. Why?

A growing number of working seniors remain active at work and enrolled on their (or their spouse's) employer-sponsored medical plan. This option is particularly attractive for workers at companies with 20 or more employees who are covered on HSA-qualified plans and actively funding their Health Savings Accounts. These seniors can reduce their taxable income by up to $5,150 (Self-only coverage) or $9,300 (family plan) by funding a Health Savings Account to the statutory limit in 2024.

They can do so, however, only by deferring enrollment in Medicare past their initial enrollment period that begins three months before the month of their 65th birthday and ends three months after that milestone celebration. If they do defer Medicare enrollment, they may pay a temporary or lifetime premium surcharge when they finally enroll in Medicare.

Medicare imposes these penalties on certain late enrollees, but not everyone. It depends on your coverage between age 65 and the month that you finally enroll in Medicare. Let's break down this complex topic so that you're armed with the information that you need to determine your optimal mix of Health Savings Account contributions, Medicare enrollment, and Social Security benefits.

Adverse Selection

Insurers are ubersensitive to a concept known as adverse selection. Insurance markets work effectively only when insurance protects policy holders against an unexpected loss that would cause serious financial loss to the person suffering the loss.

Example: You apply for life insurance. The insurer conducts a physical exam and reviews your medical records to determine how likely you are to die during the coverage period. Even if the insurer determines with 97% certainty that you're unlikely to die during the term of the insurance contract, neither you nor the insurer knows (assuming no fraud) whether you will be among the 3% who die or the 97% who live.

Insurers do everything they can to avoid adverse selection. In simple terms, adverse selection refers to the situation in which people delay insurance and then apply when they are far more likely to need someone to pay claims rather than provide protection against unknown risk. Imagine the frantic person who applies for homeowner's insurance as the home's smoke detectors are activated. They're not looking for protection against an unknown, catastrophic risk, but instead are searching for someone to reimburse their known claims. That's adverse selection.

Part B

Medicare doesn't want healthy people age 65 and older to avoid enrolling and paying premiums for Part B (physician visits, imaging, and therapy and treatment delivered outside the hospital setting, etc.) until they need such coverage. That would be the equivalent of purchasing the homeowners policy as flames engulf your home. People approaching age 65 are given two options to avoid these penalties:

1. Enroll in Part B during the Initial Enrollment Period around their 65th birthday, or
2. Retain coverage on a group plan from their 65th birthday until they enroll in Part B during a Special Enrollment Period (triggered by the loss - including voluntary disenrollment from - group coverage).

Thus, it's easy to avoid the penalty by purchasing other coverage, which may cost you less than Part B (with its monthly premium of $174.70 or more in 2024). But note that the permissible coverage after your 65th birthday doesn't include a nongroup plan or continuation of a group plan when you exercise your COBRA rights.

If you don't have permissible coverage from your 65th birthday until you enroll in Part B, you face a penalty of a lifetime 10% premium surcharge for each 12-month period that you're not covered appropriately. Thus, if you had a 16-month gap before you enrolled in Part B in 2020, your 2024 premium surcharge is $17.47 (10% of $174.70, or a total monthly premium of $192.17), or more if your income puts you into a higher premium bracket. The dollar value of the 10% premium surcharge increases as monthly premiums rise year-to-year.

Health Savings Account owners who remain covered on an HSA-qualified group plan (their own or a spouse's) after their 65th birthday can avoid this surcharge easily by promptly enrolling in Part B when they lose their group coverage.

Part D

Part D is also designed to prevent adverse selection. Created nearly four decades after Part B, it approaches the issue differently. Unlike Part B, where avoiding premium surcharges is based on maintaining group coverage, Part D penalties aren't affected by whether you prescription-drug coverage beginning with the month that you turn age 65 is a group plan, nongroup coverage, or COBRA continuation. Instead, what matters is the perceived quality of your prescription coverage.

To avoid penalties, you must be enrolled in Medicare Creditable Coverage, or MCC, from the month that you turn age 65 until you enroll in Part D. In simple terms, your coverage is or isn't MCC depending on whether it's as rich as Part D. Your insurer runs this calculation annually and informs your employer (or you, if you have nongroup coverage) by mid-October whether the plan meets the MCC standard for that year. The same prescription-drug design may barely meet the MCC standard by one insurer's calculation and barely fall below the standard through another insurer's test.

Medicare imposes a penalty for every month, beginning with your 65th birthday, that your prescription-drug coverage fails to meet the MCC standard. That penalty is equal to 1% of the Part D National Base Beneficiary Premium, nor NBBP, for each month that your coverage falls below the MCC standard. The NBBP is, in simple terms, the care monthly premium that every Part D plan charges. Insurers then add to that premium as they enrich their Part D plan.

Example: You were covered on a non-MCC drug plan during the 10 months between the month of your 65th birthday and your enrollment in Part D. You pay a permanent monthly premium surcharge of 10% of the NBBP, or $3.47 (10% of the 2024 NBBP of $34.70) on top of your premium. If your monthly premium is $55 (the average Part D premium in 2024), you pay $58.47 monthly. Your surcharge changes each year because it's a percentage of a changing NBBP.

Unfortunately, HSA-qualified plans integrate prescription-drug coverage with the medical benefit and don't allow for reimbursement of any services (except select preventive care) before you incur at least $1,600 for self-only and $3,200 for family coverage (2024 figures, rising to $1,650 and $3,300 in 2025). Many HSA-qualified plans have self-only deductibles of $2,000 or more. Those plans usually fall below the MCC standard.

There's nothing that a working senior can do to avoid this premium surcharge, short of changing coverage to a non-HSA-qualified plan at open enrollment. In that case, they can no longer make or receive contributions to their Health Savings Account.

The problem is becoming more acute with changes to the Part D program in 2025 (caps on patients' annual cost-sharing and government-dictated prices on certain medications). Thus, many working seniors who are enrolled on prescription-drug riders that satisfy the MCC standard in 2024 won't meet that threshold in 2025. And they won't know until October 2025.

Should I Enroll at Age 65 to Avoid Penalties?

So, does it make sense financially to drop group coverage at age 65 during your Initial Enrollment Period (a seven-month period extending from three months before to three months after the month of your 65th birthday) and enroll in Medicare?

It depends.

Once you enroll in any Part of Medicare, the contribution window to your Health Savings Account slams shut - almost certainly permanently. Thus, you may lose several years of your own and employer contributions that can either top off your account balance before you retire or reimburse your current qualified expenses tax-free.

On the other hand, if you reach your 65th birthday and are not covered by a group medical plan (thus triggering the Part B penalty) or a drug plan that meets the MCC standard (thereby incurring the Part D penalty), you risk incurring these lifetime premium surcharges. This scenario rarely happens. People who aren't covered by their own or a spouse's group plan at age 65 usually enroll in Medicare when they're first eligible. But if you're not covered on a group plan from age 65 to 68, you'll face a 30% lifetime surcharge on your Part B premium, plus a 36% surcharge on the National Base Beneficiary Premium of your Part D plan. You'll save three years' worth of premiums, but you won't be eligible to fund a Health Savings Account during this span.

More commonly, you're covered on an HSA-qualified plan with a prescription-drug benefit that doesn't meet the MCC standard. In that case, if you remain covered on a family plan, you can contribute an additional two-and-a-half years of contributions (Part A has a six-month retroactive-coverage provision that eliminates your final six months of Health Savings Account eligibility). You remain covered on a family plan and deposit about an additional $23,000 to your account, including employer contributions. (But note that your contributions are cut in half if you're covered on a self-only plan,)

When you do enroll in Part B three years later, you face no Part B penalty, but you're assessed a 36% (36 months at 1% monthly) monthly Part D surcharge (about $10 in 2024), or about $120 annually. The surcharge increases annually as premiums rise. But so does the value of the $23,000 contributed through investments. The break-even point (at which the surcharges exceed the additional contributions and earnings on those deposits) depends on assumptions. If we assume a 4% annual increase in Part D premiums and no earnings on the $23,000 additional balance, the breakeven age is 120. At a 1% return, the breakeven age increases to 130. If the account earns a consistent 2% annually, the breakeven age is 147. You get the point.

You must assess your lifespan and tolerance for risk when determining how long to remain engaged in Health Savings Account contributions. But with only a Part D penalty, even a deferral of 4.5 years (to age 70, minus the six-month retroactive Part A coverage), a 54% surcharge with a 2% return extends the breakeven age to 120. Lifespans that long are unheard since the antediluvian era.

Is There a Natural End Point?

You're never required to enroll in Medicare. But enrollment is automatic when you begin to collect Social Security benefits. You can defer enrolling in Social Security and increase your future monthly benefit by about 8% annually up to age 70. At that point, you can continue to defer enrollment, but your future benefit won't increase. Thus, you lose money without a corresponding benefit (larger future monthly payment) for every month beginning with your 70th birthday that you don't collect Social Security benefits.

So, here's the formula for maximizing your Health Savings Account contributions and your monthly Social Security benefit:

1. Continue to fund your Health Savings Account through age 69 1/2.
2. Begin to collect Social Security benefits during the month that you turn age 70. You'll automatically be enrolled in Medicare Part A and Part B (you can waive Part B, but Part A is mandatory), with Part A coverage retroactive six months (hence your ceasing to fund your Health Savings Account at age 69 1/2).

Note that this formula may not be the best approach for you. Your best strategy, based on available information, may be to begin to collect Social Security earlier, or even to enroll in Medicare before collecting Social Security. This formula is appropriate if you want to continue to fund your Health Savings Account as long as possible while simultaneously increasing your future monthly Social Security benefit.

The Bottom Line

Medicare penalties are real. But they're not inevitable. And they may be a price worth paying to continue to fund your Health Savings Account. But you won't know what's best for you if you don't understand the interplay of Health Savings Accounts, Medicare, and Social Security.

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HSA Wednesday Wisdom is published every other week, alternating with HSA Question of the Week. The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.