Health Care Costs in Retirement: Are You Prepared?

Even if you've been saving diligently, health care costs can throw a wrench in your retirement plans. A report from the Employee Benefit Research Institute estimates a 65-year-old couple could need as much as $351,000 in savings to have a 90% chance of covering their health care expenses—including premiums, deductibles, prescriptions, copays, and out-of-pocket costs—in retirement. Here are four strategies to consider before you reach retirement age to help minimize your cost of health care in the future.

If you're enrolled in a high-deductible health care plan (HDHP) that offers a health savings account (HSA), consider using it to sock away extra money for future medical needs. You can make tax-deductible contributions¹ of up to $4,150 for individual coverage and $8,300 for a family in 2024 ($4,300 and $8,550 respectively in 2025)—plus an additional $1,000 for those ages 55 and older, and some plans allow you to invest your HSA funds after meeting a minimum account balance.

Earnings can potentially grow tax-free, and withdrawals of contributions and earnings are tax- and penalty-free when used for qualified health care expenses, including Medicare and long-term care (LTC) insurance premiums. And once you reach age 65, withdrawals from an HSA can be used for any purpose without penalty, although ordinary income taxes will apply to funds used for nonmedical expenses.

Most near-retirees know Medicare becomes available at age 65, but fewer realize there's a permanent penalty for missing the initial enrollment period (IEP). Your IEP is a seven-month span, including the three months before, the month of, and the three months following your 65th birthday. If you fail to apply during your IEP for Medicare Part B—which covers most everyday (outpatient) medical expenses—your monthly Part B premiums could go up 10% for every 12-month period you go without coverage. There's also a 1% penalty per month for each month you delay enrolling in Part D prescription drug coverage (see "The ABCDs of Medicare").

If you begin collecting Social Security before your 65th birthday, you'll automatically be enrolled in Medicare Part A (which covers hospital stays and is generally premium-free) and Part B. But if you plan on waiting to collect Social Security, be sure to apply for Medicare as soon as you're eligible.

Be aware that Medicare coverage can be affected if you or your spouse is still working and enrolled in an employer's health care plan. For example, if you work for a large company, you may be able to delay signing up for Part A and Part B without penalty until your workplace coverage ends. Generally, you may also want to postpone enrolling in Part A if you intend to stay with your group health insurance or you want to keep contributing to an HSA after age 65. Your human resource department can explain how Medicare works with your health plan to help guide your decisions.

Once you or your spouse no longer has creditable employer-sponsored health insurance, you'll have up to eight months to sign up for Medicare during a special enrollment period (SEP) to avoid penalties. That said, best practice is to cease contributing to your HSA six months before you start receiving Medicare benefits.

Medicare premiums are affected by your modified adjusted gross income (MAGI), and relatively higher-earning retirees may also be subject to Medicare's Income-Related Monthly Adjustment Amount (IRMAA). MAGI for IRMAA is generally calculated as the sum of your adjusted gross income (AGI) plus tax-exempt interest from your tax return from two years prior.

You can expect this surcharge on your monthly premiums for Parts B and D if your MAGI from 2023 exceeded $106,000 ($212,000 for married couples filing jointly). The differences in premiums for Part B, in particular, can be steep, so taking steps to reduce your MAGI could lower your medical costs as well.

The higher your income, the more you can expect to pay for Medicare in 2025.

If most of your retirement savings are in tax-deferred accounts that are subject to taxable required minimum distributions (RMDs), which will increase your MAGI when taken, you may want to consider converting some of those funds to a Roth IRA or, if offered by your employer, a Roth 401(k). Roths offers tax-free withdrawals once you reach age 59½ and have held the account for five years. You'll have to pay taxes on the converted amount in the year of the conversion, but Roths are not subject to RMDs, helping you to better manage your MAGI in retirement.

Bear in mind the two-year look-back rule when you evaluate the timing of the conversion. If your income from two years ago is higher than your current MAGI and you experience a life-changing event, including retirement, you can apply for an exception to your reduce your Part B and/or D premiums using Social Security Form SSA-44.

If you must take RMDs, you can take a qualified charitable distribution (QCD) to help reduce your MAGI. With a QCD, you can donate up to $105,000 in 2024 ($108,000 in 2025) to a qualified charity directly from your retirement account, which could satisfy all or part of your RMD. Although you can't deduct a QCD as a charitable contribution, the withdrawal won't count as taxable income.

Long-term care covers the costs of activities of daily living and can be a significant risk to your financial situation in retirement without careful planning. Long-term care insurance can seem costly—annual premiums with 3% growth for a healthy 60-year-old average $2,585 for males and $4,400 for females—but with the median annual cost of a private room in a nursing home at $116,800, it may be more expensive not to have it. Generally speaking, the most cost-effective time to buy is in your 50s to early 60s, and premiums may be tax-deductible if your overall medical expenses exceed 7.5% of your income. A financial planner can help you strategize ways to structure insurance to dampen the risk of future long-term care costs as well as discuss alternatives.

With the cost of care showing no signs of declining, taking steps before you retire can help you manage future health expenses—making this an important part of your financial planning strategy.