As income investors watch their dividend stocks they've held for many years...in some case decades...gradually appreciate to multiples of their basis (what they originally paid for them), for such stocks held in a taxable account, there are a couple of potential financial land mines the investor needs to be aware of. If these high dividend growth stocks are held primarily in a Traditional IRA (TIRA), they likely are appreciating faster than the withdrawal rate if they are being withdrawn at all. Either way, the household is at risk of a significant jump in the household's Modified Adjusted Gross Income (MAGI) in future years. If this occurs in years the household principals are age 65 and older thus are subject to Medicare enrollment and Required Minimum Distributions ((RMDs)) at age 70.5 and beyond, a Medicare Premium Surcharge may become a reality. But first, let's review the rules.
The Medicare Income-Related Monthly Adjustment Amount (IRMAA)
For higher income households, Medicare may required both a Part B premium and Part D premium surcharge or IRMAA if the retired household's MAGI reaches a certain level.
Medicare uses the tax return of two years prior to the current tax year for the MAGI information and to assess the possible IRMAA in the current year. So for the 2017 calendar year, Medicare will use the tax return information from the 2015 year. If this is not available, Medicare will use the household's 2014 return.
Generally, Medicare will accept the MAGI information as reported to the IRS and apply the IRMAA to the current year, but will allow the household subject to IRMAA to appeal this surcharge if any of the following "life-events" occur that have since reduced household MAGI (This request must be made using the form SSA-44)
- Marital change, to include marriage, divorce or spousal death
- Loss of income producing property not controllable by the taxpayer
- Involuntary change in employer pension plan
- Receipt of any settlement from prior employer due to closure, bankruptcy or dissolution
- Retirement or reduction in work load that is not reversible
Events that will generally not reduce MAGI include
- One-time gains from exercised employee stock options
- Increase in household expenses whether deductible or not
- Unexpected one-time gains from investments or company securities
- Taxable gain on the sale of a personal residence
- Maturity/redemption of appreciated bonds or preferred stock
The primary difference between MAGI events that are allowable and not allowable is taxpayer discretion. SSA Program Operating Manual (POM) 01120.035 defines risk of investment gain or loss inherent in the investment to be discretionary to the beneficiary, even though the beneficiary had no control over the gain or loss. Further, investment loss due to fraud is only considered as an adjustment to MAGI if the perpetrator of the fraud is convicted of fraud.
What does the income investor need to be aware of in the planning necessary to avoid the IRMAA?
Highly appreciated income securities
As an income investor, it is rare that I will ever sell a dividend paying stock that is reliably paying and growing its dividend. In a taxable account over the years this can create a large amount of unrealized capital gains. For example, buying 1,000 shares of Public Storage Inc. (NYSE:PSA) in early 2000 at $22/share has resulted in a very reliable source of growing income, but has also resulted in an unrealized long term capital gain (LTCG) of over $194,000. The good news is the income investor has not had to pay any tax on this large gain and if he/she is holding these shares at death, under current estate tax law, they will step-up in basis to fair market value on the day of death meaning no tax was ever paid on the capital gain. The not so good news is that if PSA were to decide to go private due to a new 15% corporate tax rate, all of that unrealized LTCG would be added to the income investors MAGI. If the income investor had initially selected well, this kind of highly appreciated income stock could occur many times in a diversified income portfolio.
What could the income investor do to prevent this kind of situation?
- Keep initial purchases low, that is, the income from any single security should provide no more than 3% of the portfolio's income
- Periodically sell and immediately repurchase a block of highly appreciated stock in a taxable account, particularly when the income investor is in the 15% tax bracket, as the net LTCG will be taxed at 0%, at least under current tax law. This has the effect of gradually 'stepping up' the basis of the stock.
- For normal or regular charitable giving, use the highly appreciated stock shares as the gift. For example, if one gives $1,000 per year to a 501(c)(3) charity, gifting the charity 10 shares of a stock valued at $100/share with a basis of $10 will result in a deductible $1,000 gift with the income investor then using the $1,000 in cash planned for the gift to buy back the 10 shares of stock.
- In a year of unplanned and non-elective LTCG, sell any capital losses and then repurchase the shares….assuming the income investor wants to continue holding them….31 days later to avoid a wash sale. The capital loss will reduce the LTCG dollar for dollar.
Required Minimum Distributions
For higher income retirement households that have not been using TIRA withdrawals because they are consciously being delayed to allow maximum tax deferral, or, sufficient income is provided by other sources such as part time work or through the sale of assets, the ultimate RMD may become very large. For example, a couple retiring at age 64 have a combined $1.4MM in TIRAs after rollover of retirement plan balances, but who are temporarily drawing sufficient income from a 5 year deferred compensation plan, Social Security and real estate rental income providing a MAGI of $130,000. If TIRA withdrawals are delayed to the first RMD year, at an average annual growth rate of 8%, in 6 years the TIRAs will have grown to $2.2MM, with the first year RMD of about $81,000.
What could the income investor do to prevent this kind of situation?
- Do Roth conversions each year for any amount of 'headroom' in the 15% tax bracket, where 'headroom' is the difference between the top of the 15% tax bracket ($75,900 for 2017) and Taxable Income (line 43 of form 1040) for those married filing jointly.
- If the household has charitable intent, consider using the Qualified Charitable Distribution (QCD)of at least that part of the RMD that would put their MAGI over the IRMAA threshold. There are a number of rules and restrictions on the use of the QCD that must be learned before using this approach. For example, the QCD cannot be made until the individual is 70 ½, not anytime during the year the individual attains age 70 ½. The QCD must be physically received by the charity by December 31 of the donation year, it is irrevocable once made, it must be an agent-to-agent transfer, the amount may be up to $100,000 even if this exceeds that year's RMD amount and so on. For a more thorough discussion on QCD rules, read the excellent article on this topic by Michael Kitces.
Careful planning can help reduce the risk of IRMAA. However, one must never lose sight of the larger financial picture. It has never made sense to spend a dollar to save 50 cents, and it never will. The greater tax of doing a TIRA to Roth IRA conversion in the years leading up to the first RMD will increase the tax bill over those years. This can then be compared to the tax savings in future RIRA withdrawals instead of withdrawing the same dollars from a TIRA plus the savings of not paying the IRMAA. Similarly, the added tax of realizing capital gains on highly appreciated dividend paying stocks in taxable accounts must then be compared to the IRMAA expense were the appreciated stocks non-electively sold in later years. And it must be remembered that the IRMAA is a threshold surcharge: even $1 in MAGI in excess of the thresholds shown in the table above will trigger the IRMAA for that MAGI range. So if Roth conversions or sale-repurchase of appreciated stock or use of the QCD is considered, it must be done with the quantifiable goals of reducing the MAGI below the thresholds…not just reducing MAGI generally.
I hope this article has helped to create awareness of the IRMAA and how it is calculated, but more importantly, to provide some ideas for a starting point in working to avoid the IRMAA if it makes financial sense to do so.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.