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Many people who retire before age 65 rely on the Affordable Care Act (ACA) marketplace for health insurance until they qualify for Medicare. As policymakers debate whether to extend enhanced premium subsidies, some early retirees are waiting anxiously before making their next move.
For households that retire in their late 50s or early 60s, the difference between subsidized and unsubsidized premiums can be substantial — sometimes $15,000 to $20,000 a year.
But even if those enhanced subsidies remain in place, there’s a bigger issue many affluent early retirees overlook. In my experience working with retirees who have $2 million or more saved in 401(k)s and IRAs, chasing health insurance subsidies can end up costing far more in the long run.
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The reason? It all comes down to taxes.
Suppressing early retirement income to chase ACA subsidies
When people retire before 65, they often discover that ACA subsidies are tied to income, giving them some control over what they pay for health insurance. The lower your modified adjusted gross income (MAGI), the larger the subsidy for your premiums.
As a result, many retirees intentionally suppress their income for several years. They withdraw only the minimum they need from retirement accounts. They avoid realizing capital gains.
And most importantly, they avoid Roth conversions because converting money from a traditional IRA to a Roth IRA increases taxable income.
At first glance, the strategy might seem sensible. If a couple can save $15,000 to $20,000 a year on health insurance premiums by keeping income below certain thresholds, the savings over five years until Medicare eligibility can reach $75,000 to $100,000.
But these short-term savings often create a much larger long-term tax problem.
The hidden cost of postponing Roth conversions
For early retirees with large tax-deferred accounts, the years between retirement and age 65 can be one of the most valuable tax-planning windows of their lifetime.
During this period, income is often lower than it will be later in retirement. Social Security may not have started yet. Required minimum distributions (RMDs) haven’t kicked in. And couples can still file taxes jointly.
This can make it an ideal time to convert portions of traditional retirement accounts into Roth IRAs while staying within relatively low tax brackets.
However, when retirees suppress income to qualify for ACA subsidies, they often postpone those conversions.
Meanwhile, their tax-deferred accounts continue growing. For example, a retiree who delays conversions on a $2.5 million IRA could see that balance grow to $3.5 million or more by their early 70s, assuming modest market growth over roughly a decade.
That increase alone can significantly raise required distributions and the taxes that come with them for the rest of retirement.
Three tax surprises that often follow
Several tax rules compound the impact of delaying conversions.
1. RMDs
Under current law, retirees must begin taking RMDs from traditional retirement accounts starting at age 73 or 75. These withdrawals are taxed as ordinary income, whether the retiree needs the money or not.
For a 73-year-old with $3 million or more in pretax retirement accounts, the first RMD alone can exceed $100,000, and it often increases over time. At age 75, that first RMD is $121,000 a year.
That income can push retirees into higher tax brackets and reduce their flexibility to manage taxes later in retirement.
2. Medicare premium surcharges
Higher income in retirement can also trigger IRMAA, the income-related monthly adjustment amount that increases Medicare premiums. These surcharges apply when income exceeds certain thresholds and can add thousands of dollars a year to health care costs.
Ironically, retirees who spent years limiting income to obtain ACA subsidies may end up paying significantly higher Medicare premiums later because of larger retirement account balances.
3. The surviving spouse tax problem
Perhaps the most overlooked issue occurs when one spouse dies. When a couple goes from filing jointly to filing as a single taxpayer, tax brackets become much narrower.
If the surviving spouse still has large RMDs, they may suddenly find themselves paying taxes at much higher rates on the same income. This “widow’s penalty” is a common consequence of large tax-deferred accounts that were never gradually converted during lower-tax years.
When retirees run the math over a full retirement timeline, the trade-off becomes clearer. Saving $75,000 to $100,000 in ACA subsidies can feel significant in the moment. But delaying Roth conversions for several years can increase lifetime taxes by hundreds of thousands of dollars in some scenarios.The good news is that with intentional planning, many retirees can capture some subsidy benefit without sacrificing their long-term tax position.
How to avoid the ACA subsidy trap
If you’re planning to retire before age 65, here are a few ways to approach ACA subsidies without undermining your long-term tax strategy:
- Evaluate taxes over your lifetime, not just this year. Before limiting income to qualify for subsidies, model how that decision impacts taxes in your 70s and beyond, especially once RMDs begin.
- Use the early retirement window strategically. The years between retirement and age 65 are often your best opportunity to complete Roth conversions at relatively low tax rates. Don’t let subsidy thresholds prevent you from using that window.
- Consider partial Roth conversions. Instead of avoiding conversions entirely, you may be able to convert enough each year to stay within a reasonable tax bracket even if it means accepting a smaller subsidy.
- Plan for Medicare and IRMAA early. Higher income later in retirement can increase Medicare premiums. Managing account balances earlier can help reduce those future surcharges.
- Coordinate your withdrawal strategy. Where you draw income from — taxable, tax-deferred or Roth accounts — can significantly impact both your subsidy eligibility and long-term tax exposure.
Think in terms of lifetime planning
Health care subsidies are a real benefit worth evaluating. But for retirees with significant 401(k) or IRA balances, the more important question is whether maximizing subsidies today creates a larger tax problem tomorrow.
