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Balance (photo credit)

Optimizing Obamacare vs Minimizing Taxes presents a classic trade-off.

On the one hand, it would be nice to maximize Obamacare subsidies.  Easy! Simply don’t generate a lot of income.

On the other hand, we want to minimize taxes. We do this by offsetting income with standard deductions and personal exemptions, and generating (a large amount of) income that has preferential tax treatment.

But for the ACA, there is no preferential tax treatment.  There is no standard deduction, no personal exemptions.

In this post, I explore how to navigate this complex environment in order to optimize health insurance premiums, out of pocket medical expenses, and taxes.  Can we find the balance?

Tax Minimization

As part of my quest to Never Pay Taxes Again, I’ve read a lot of tax documentation.  What can I say, everyone needs a hobby.

The process is simple. We convert our tax-deferred 401ks and IRAs to Roth IRAs at zero or low marginal tax rates, invest in index funds that pay Qualified Dividends, and Harvest Capital Gains to increase our basis.  Doing this, it is possible for a Married Couple Filing Jointly in 2015 to have $95,500 in income and pay $0 in tax.  (See a real world example for 2014.)

In some cases, it might make sense to pay a little tax now to avoid larger tax bills in the future, a real possibility with Required Minimum Distributions.  We might then double the size of our Roth IRA Conversion to occupy all of the 10% marginal rate (or even part of the 15%) and harvest a little less in capital gains.  Same $95,500 income, but with a reasonable tax bill of only $2,000 or so and smaller RMDs down the road.

An example is shown below for a Married Couple Filing Jointly / 2-Person Household.  For Single, divide by 2.  For 3+ Person households, shift tax curves right by $4k/additional dependent

Federal_Tax_Profile_MFJ3

Tax Minimization for Federal Tax Profiles

Now with the Affordable Care Act, the process is no longer so simple

Affordable Care Act as a Tax

Affordable Care Act subsidies decrease as income increases. A marginal loss of a tax credit is equivalent to an increase in the marginal tax rate.  Ergo the ACA is a tax.

Unlike the Federal Income Tax, all income sources included in MAGI are taxed against the ACA tax profile, including Roth IRA Conversions, Qualified Dividends, and Long Term Capital Gains.

ACA_Tax_Profile2

Affordable Care Act Tax Profile

There are 3 taxes shown in the chart

  • Premium Tax Credits are reduced using an inverse marginal taxation profile for MAGI up to 400%.  Total tax is bounded; beyond 400% additional income is tax free.
  • Out of Pocket Maximums may increase as income increases beyond 200% & 250%. Shown as impulses, CSR 87 & CSR 73
  • A subsidy cliff may increase insurance premiums above 400%, particularly in high cost states and for older retirees.  Shown as Subsidy Cliff impulse.

If any of this doesn’t make sense, background information is covered in the post Obamacare Optimization in Early Retirement.

These taxes can all be quantified, allowing us to compare against alternatives.

Note: Most states have expanded Medicaid for low income households. For those states, income must exceed 138% FPL to qualify for ACA which eliminates that cute little 2% marginal rate lobe (difference in total tax is minor.)

Quantifying CSR Subsidies

For silver plans only, at 200% and 250% FPL the Out of Pocket (OOP) Legal Limits increase.  (There is also a CSR subsidy reduction at 150% FPL that I’m excluding since it doesn’t impact OOP.)

An insurance company will implement this via higher deductibles, co-pays, and co-insurance.  In a year with limited medical use, the value of this subsidy may be zero.  But in a year with significant health expenses, the Out of Pocket Maximum can save thousands of dollars.  These are legal limits, the actual changes may be lower.

<200% FPL – $2250 single / $4500 family
200% FPL – $5200 single / $10400 family (+$2950/+$5900)
250% FPL – $6600 single /$13200 family (+$1400/+$2800)

Quantifying Subsidy Cliff

The impact of the Subsidy Cliff is relatively easy to determine.  The legal limit for cost of premiums is 9.5% of MAGI at 400% FPL.  At $400% + $1, the delta to the actual premium can be zero or it can be thousands of dollars.  (We previously saw examples of a cliff from -$1k to +$4k.)

Legally, older people can be charged 3x younger people, which means the subsidy cliff will grow substantially with age.  As long as we stay below 400% FPL this isn’t a factor at all, the premiums are independent of age.

Tax Implications

When we superimpose the ACA Tax profile for a 138% State on the Federal Tax profile, things get interesting.

Fed_ACA_profile_taxminarrows1

Combined Federal & ACA Tax Profiles

Pre-ACA, it was inconceivable to see 25%+ tax rates on income of less than ~$100k.  Now, households at 138% FPL will. Non-dividend incomes above 250% FPL will see 30% tax rates.

Qualified Dividends and Long Term Capital Gains no longer see a generous 0% tax rate, and will be partially taxed at 9.5% & 15%.

The capital gains we planned to harvest at 0% tax now cause us to blow past the 400% FPL level, losing all subsidies and falling off the subsidy cliff.

This has profound implications.  The opportunity space for tax minimization has been reduced significantly (highlighted in chart below.)

Opportunity Space for 10% Roth / 0% Dividends and 0% Capital Gains

Opportunity Space for 10% Roth/0% Dividends and 0% Capital Gains

Further complicating matters, household size is now a major factor in tax minimization due to use of multiples of the FPL. A married couple at 400% FPL is still early in the 15% Federal marginal rate.  A family of 5 would have already crossed into the 25% bracket.  One Size Does Not Fit All.

Opportunity Space Household Sizes1Single people and large families have limited or zero opportunity to harvest tax free capital gains, whereas 2 and 3 person households have a large amount.  10% Roth space increases with family size due to personal exemptions, except for single households which have the most.

Household12345
FPL$11670$15730$19790$23850$27910
Size of 0% space ($)$10300$20600$24600$28600$32600
Size of 10% space ($)$5805$1107$2710$4313$5916
Percent of 10% bracket56%5%11%15%18%
0% CG space$1070$32580$20340$8100$0

Tax Minimization with the ACA

To begin, we need to at least qualify for the ACA.  In most states, this requires a minimum of 138% FPL.  With a combination of qualified dividends and other income, the tax bill could be $0 and insurance would cost only 3.29% of MAGI.  I use this as a baseline.  (In some states, 100% of FPL is the qualifying minimum.  The tax delta to the 138% FPL case is small)

Households below this threshold in most cases will be on Medicaid.  Some say Medicaid is the best insurance they ever had, so don’t automatically discount it. But make sure this is intentional.

Any additional income of any kind will increase tax burden. We could minimize today’s taxes / maximize ACA subsidies by keeping income at 138% of FPL, but at the expense of a potential greater future tax bill.  If we can find a combination of actions that result in a low average tax rate, then it would be worth pursuing.

10% Roth Conversion / 0% Dividend Tax Space

If non-dividend/capital gain income is less than 138% FPL & total MAGI is less than 400%, we have a choice of how to use the remaining portion of the 10% Federal Tax bracket (shaded region in Opportunity Space chart.)  We can either do a Roth Conversion and pay 10% tax, or leave it for tax free qualified dividends/long term capital gains.

This decision should be driven by the RMD.  If we expect the RMD to result in a tax rate higher than 10%, we will minimize lifetime taxes by increasing the size of today’s Roth Conversion.

Above 138% FPL, we face an effective tax rate of 25%.  If RMDs will cause 28%+ tax rates in the future, it may be worth converting more funds.  Otherwise, 138% FPL is a hard stop on Roth conversion size.

0% Capital Gain Tax Space

The inverse marginal tax profile (tax rate decreases as income increases) on dividends/capital gains provides an incentive to harvest gains whenever possible.  We can minimize the effective tax rate by averaging the tax over more income (Household Size = 2,3,4.)

Using 138% FPL as a base, if we only have dividend/capital gain up to 400% FPL, we would pay an effective tax rate of 12.9% (area under the ACA tax profile curve.)  But if we harvest all the way to the top of the 15% federal tax bracket, we can reduce that to 7.2% for a 2-person household (excluding subsidy cliff.)  A $1k subsidy cliff would increase this to 8.6%.  This isn’t zero, but it is better than 15%.  If we are going to push over the 400% FPL level, we should push all the way as long as the subsidy cliff is not too punitive.

Effective Qualified Dividend/Long Term Capital Gain Tax Rates

Example Effective Qualified Dividend/Long Term Capital Gain Tax Rates

Some households will earn at a higher income level by default, so effective tax rates are shown for various base MAGI levels from 138% to 300%.  (e.g. If a household earns 300% FPL as a minimum, that is the base upon which marginal changes take effect.)

Additional subsidy loss via CSR phaseout or the Subsidy Cliff will increase the effective tax rate.  This is shown as a percentage on a per $1000 basis, e.g. if a 1 person household with a 250% FPL base loses $1,000 in subsidies due to harvesting capital gains, this will increase the effective tax rate by 5.4%, from 10.7% to 16.1%.  In these circumstances, harvesting gains may not be worth it.

This table shows the effective tax rate for harvesting gains from various tax bases up to the top of the 15% marginal rate.  The impact from subsidy reductions are shown in parenthesis per $1k.

Household →
ACA tax base (↓)
12345
138% (+$1k)12.5% (3.2%)7.2% (1.4%)9.3% (1.4%)11.4% (1.4%)13.7% (1.4%)
200% (+$1k)11.7% (4.1%)6.0% (1.6%)8.1% (1.7%)11.3% (1.5%)13.6% (1.5%)
250% (+$1k)10.7% (5.4%)4.8% (1.8%)6.7% (2.0%)9.2% (2.3%)12.6% (2.7%)
300% (+$1k)8.7% (7.8%)3.1% (2.1%)4.7% (2.5%)7.1% (3.1%)11.2% (4.2%)
400% Cliff Only/$1k93.5%3.1%4.9%12.3%NA

If We Were In the US

Accumulation

Knowing that we would face 25%+ subsidy reductions for Roth IRA conversions, I would no longer focus on a Traditional 401k and IRA to accumulate retirement savings.  Instead, I would accumulate savings in a combination of Roth/Traditional/Taxable.  I know making this statement will make several people very happy 🙂

While young and healthy, I would choose a health plan with an HSA for additional tax deferred savings.

Traditional accounts alone result in paying more taxes in retirement than while working, as an income in the 95th percentile is required to pay tax at a rate greater than 25%. And if income is greater than 400% FPL, we don’t even get an increased ACA subsidy for the contribution.

Roth accounts alone may not enable us to generate 138% FPL annually, since Roth withdrawals don’t contribute to MAGI.

Even at the 25% marginal rate while working, maxing out a Roth 401k is more appealing than paying 25% tax post retirement due to an interesting phenomenon that exists with Roths at higher tax rates.  If we contribute the max to a Roth at the 25% marginal rate, we have an effective ~7% increase in after-tax purchasing power over contributing the same amount to a Traditional and investing tax savings in a brokerage account.  (Harry Sit the Finance Buff explains this well. The Boglehead’s wiki also has a good overview.)

Ideally though, we would contribute to Roth accounts early in a career when income was lower, and then to Traditional accounts as income rose to higher levels.

Post Retirement

We would establish legal residence in a state with no income tax.  I would do Roth IRA conversions each year to fill up the 0% tax space.  Roth conversions and dividend income from the brokerage accounts would insure we were above the 138% FPL threshold.

Since total annual spending is higher, we could draw down savings that don’t contribute to MAGI, including cash, basis in stock held in a brokerage account, and Roth IRA withdrawals (Contributions only before Age 59.5.)

While young, when the subsidy cliff is not a problem I would wait until the last trading day of the year.  On this day, I could harvest capital gains up to the top of the 15% tax bracket in years where it made sense, and then be sure not to do anything stupid that might require medical care until midnight on Dec 31st.  In years that required a large amount of medical care, we would do no capital gain harvesting for the maximum CSR subsidies.

In this way, I could still convert all of our traditional accounts to Roths at a 0% tax rate.  And we could harvest capital gains at an effective tax rate of less than 7% (with an effective negative subsidy cliff.) Over all income, it would be ~5% effective tax rate.  On occasion, we could follow the same practice but while spending a year abroad, with an even lower effective tax rate.

A perpetual 7% annual tax on gains wouldn’t be ideal, so this wouldn’t be something I would do every year.

As we age, eventually the Traditional accounts will go to zero due to the Roth IRA conversions, probably before we ever see an RMD.  If this appeared to be the case, we could reduce the size of Roth conversions and give a little more tax space to tax free dividends.

When the Traditional accounts were depleted, we could then harvest gains at 0% up to the 138% FPL level.

As the subsidy cliff increased in size with age, I would put a halt to any large scale gain harvesting. Or at least until we reach Medicare age and the ACA no longer applies. By the time we reached Age 70.5, we would likely be 100% tax free.

Alternatives

  • Ignore all of this.  We need insurance, we pay full price for it. Or do a minimal amount of Obamacare Optimization to avoid the subsidy cliff

Worst case, we pay full price for health insurance.  Perhaps it is the patriotic thing to do.  The full loss of subsidy is just the area under the ACA tax curve, plus any impact from the loss of CSR subsidies and the subsidy cliff.  We could just include this into our target annual expenses.

Household
12345
Max subsidy from 138% FPL$3944$5317$6689$8061$9040
  • Pay the penalty

We could choose to self-insure and pay the individual mandate penalty. In practice, for most people this would look like a 2.5% tax rate. With healthcare prices in the US, this may be like playing Russian Roulette.  Some are less risk averse.

In 2016, the penalty is the higher of:
– $695/adult ($387.50/child) (max of $2,085/family)- 2.5% of MAGI above filing threshold (standard deduction + personal exemptions)

Absolute max is national avg price for a Bronze plan.  For 2014, this is $2,448 per individual but $12,240 for a family with five or more members.

  • Be Exempt from the ACA

The list of exemptions from the ACA is limited, and includes fun things like being incarcerated (always a frugal living option.)

PT Money has written up an example of exemption by being a member of a health care sharing ministry. It is an interesting read about an alternative to traditional health insurance.

  • Live abroad, even if just for a year

If we were in the US, we would have ACA health insurance.  Probably.  Maybe.

But because we are outside the US for more than 330 days per year, we are exempt.  Certainly living abroad isn’t for everyone.  A lot of people have very good reasons to stay in the United States, and many more don’t have good reasons but are going to stay anyway.

As a family of 3, we are able to do large Roth IRA conversions and harvest large amounts of capital gains every year, saving us ~$7k in ACA tax.  Subtracting the cost of international health care from that, it is enough to pay for several months of living in many countries. If/when we return to the US, we are in a stronger financial position to optimize the ACA.

Final Thoughts

The interaction between the Federal Income Tax and the ACA is one of the most complex things I’ve modeled in a long time, even more so than many engineering problems I’ve worked through.  I’m sure I’ve only just scratched the surface, and my thinking will evolve as I learn more.  I’ve probably even made some assumptions that won’t hold up over time.

The ACA is still new and politically unstable.  The next few decades are likely to bring massive change to US healthcare, so it would be prudent to take the long view.  By this I mean taking steps solely for the purpose of optimizing Obamacare or minimizing taxes is probably going to lead to disappointment.  We can instead find a reasonable balance in the current environment and be prepared for change, hopefully for the better.

In many ways, I feel our current solution of a life of perpetual travel is the ideal balance.  It is certainly an easier problem set.  Maybe you’ll join us, even if just for a year or two.

In any case, I hope this can be the start of an interesting discussion.

Retire Early. Travel the World.

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