Will Tax Reform Force Medicare Cuts?

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The Tax Cuts and Jobs Act passed by Congress last month is forecast to increase the deficit by approximately $1.5 trillion over the next 10 years. How will the government make that money up? One distinct possibility is by cutting federal funding for Medicare and Medicaid.

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Balancing the budget

Tax cuts are eternally popular, but they come at a price. The money the government collects in taxes pays for various social programs, including Social Security, Medicare, Medicaid, and so on. So if taxes are reduced, the government must reduce funding to social programs to compensate -- and those funding cuts can be devastating for the people depending on these programs.

Medicare's financial woes

The threat of lost funding for Medicare could not come at a worse time, as the program is already in financial trouble. Medicare gets its money from two different trust funds: the Hospital Insurance Fund, which is funded from payroll taxes and a few other sources, and the Supplementary Medical Insurance Fund, which is supplied from Congressional funding and premiums paid by enrollees.

Medicare is in the same predicament as Social Security: The climbing number of retirees means that Medicare payroll taxes can no longer keep up with the benefits the program must pay. As a result, the Hospital Insurance Fund is projected to run out of money by 2029, leaving only enough income to pay for 88% of hospital-related Medicare coverage.

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It's unlikely that Medicare will simply be left to crash and burn. For that matter, even if legislators don't intervene by 2029, the program will still be able to limp along in a somewhat diminished form. However, the combination of existing budget shortfalls and potential cuts means that we could see Medicare benefits reduced, premiums hiked, or both. In any case, retirees can expect to shell out a lot more for healthcare.

Preparing for Medicare cuts

The specter of looming Medicare funding reductions means workers should budget way more money for healthcare expenses in retirement. Healthcare is already a major expense for retirees: One Fidelity Investments study found that a 65-year-old couple retiring in 2017 will spend an average of $275,000 on medical-related expenses. If Medicare's budget is slashed, you can expect that number to spike even higher. That means you'll need to contribute more money to your retirement savings accounts during your working years to cover inflated medical expenses later in life.

It's also wise to learn about Medicare and how to choose a policy well in advance so that once you enter your initial enrollment period, you'll be able to quickly choose the right plan or plans. For example, you'll need to decide whether to choose a Medigap policy to supplement basic Medicare coverage, or to select a Medicare Advantage plan to replace Medicare Parts A and B and providing additional coverage (for example, many Medicare Advantage plans cover services like dental, vision, and prescription drugs).

Finally, consider signing up for a high-deductible health insurance policy during your working years and funding a health savings account. HSAs offer a triple tax advantage, plus you can use the money in the account at any time for qualified medical expenses. If you contribute more than you end up spending on healthcare costs, the remaining funds can be extremely helpful after you retire: Once you turn 65, you can spend your HSA dollars on anything without incurring a tax penalty, though you'll pay income taxes on withdrawals that don't go toward medical expenses.

The HSA annual contribution limit for 2018 is $3,450 for self-only policies and $6,900 for family policies. If you saved $3,450 every year in your health savings account, investing the money in stocks that returned 8% per year and not spending any of it, then after 20 years you'd have $170,509 in the account. What's more, assuming you're in the 25% tax bracket, you'd have saved $17,250 in income taxes during those years thanks to the HSA contribution deduction. So not only would you have much more money to cover retirement expenses, but you'd also get a significant tax break now.

Long-term care is expensive, too

One way to reduce your overall medical expenses in retirement is to purchase a long-term care insurance policy. That won't help with things like medical procedures, but long-term care can be an exceedingly costly expense, and it's (mostly) not covered by Medicare. Further, the likelihood that you'll need such care is high. If your long-term care costs are covered by a separate policy, then you'll have more money to dedicate to other healthcare expenses that also aren't covered by Medicare. The best time to start pricing such policies is in your 50s, as long-term care insurance premiums tend to be much lower at that age than they would be for someone who's already retired.

Long-term care insurance premiums vary based on your age, health, the options you select, but you can expect to pay a few thousand dollars a year -- and premiums usually rise over time. On the other hand, it's much easier to budget for an insurance premium (which is fairly predictable) than it is to budget for long-term care expenses themselves, as you have no idea when such care will be needed or how much it will cost. Some employers offer long-term care coverage or make group policies available to employees; this could significantly reduce your expenses, so check with your HR representative to see if this is an option for you.

If you do buy a policy well in advance of retirement, consider looking for one with inflation-indexed benefits. Many long-term care policies will provide coverage to the tune of a set amount per day -- for example, $150 per day for nursing home care and $60 per day for home healthcare. If you don't actually need to use this coverage until 20 years after buying the policy, those daily limits might no longer be realistic thanks to rising costs for these services. A policy with inflation-indexed benefits will increase its coverage limits over time, which should make said limits far more practical a few decades down the line.

Taking these precautions will require you to spend more money before you retire, but at least you'll be able to afford the healthcare you need after retirement. What's more, having the bulwark of well-chosen insurance policies and enough savings to cover emergency healthcare expenses means you'll have far less likelihood of running out of money during retirement. At the very least, it will give you one less thing to worry about.

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