Tax Planning and Health Insurance Premium Subsidies under the Affordable Care Act
A robust research literature has developed around tax planning opportunities for retirement to manage “nonlinearities” in the tax code. Those nonlinearities include the Social Security “tax torpedo,” the stacking of preferential income sources (qualified dividends, long-term capital gains) on top of ordinary income, the triggering of Medicare premium surcharges when income exceeds certain thresholds, and the net investment income tax. Another matter that has been less explored but which can have large impacts on the marginal tax rates faced by individuals who obtain health insurance coverage through the Affordable Care Act (ACA) exchanges is the reduction of the tax credits (or subsidies) for health insurance coverage as incomes increase.
Generating taxable income can lead to thousands of dollars of lost subsidies to help cover the cost of health insurance. Early retirees who are not yet eligible for Medicare (most individuals will achieve Medicare eligibility in the month they reach age 65) and who buy health insurance through healthcare.gov or the state insurance exchanges, will want to consider the impact of lost health insurance subsidies as part of their marginal tax rate on any tax planning strategies such as Roth conversions or capital gains harvesting.
I will consider the situation under the current rules extended by the Inflation Reduction Act. These rules continue enhanced subsidies through the end of 2025 that were first introduced in 2021. Unless a further extension happens, the law will revert to less generous subsidies in 2026. As part of that reversion, the “subsidy cliff” will return, as there can be a steep drop in subsidies by thousands of dollars as soon as income exceeds 400% of the federal poverty level for the household by just $1. This will create a different problem for retirees who might have an opportunity to stay below the 400% threshold. But it also means that for tax planning purposes, there is no additional marginal tax from lost subsidies once individuals are above that threshold. For early retirees who may again face the subsidy cliff before reaching Medicare eligibility, this might be an additional short-term opportunity to do more strategic tax planning before 2026. This article focuses on the system in place through 2025, which does not include that subsidy cliff.
The health insurance subsidy available is based on a percentage of income one is deemed to be able to afford for healthcare and on the premium of the benchmark health insurance plan in the county where one lives. This benchmark plan is the second-to-least expensive Silver plan available in the county, and its premium varies quite a bit across the country. The plan premium is also based on the ages and tobacco-use status of those who will be covered by the insurance. Health plans are available as Bronze, Silver, Gold, and Platinum, with premiums generally increasing and out-of-pocket costs decreasing as one progresses through the list. Policymakers wish to ensure that a Silver plan remains affordable, though individuals may choose any plan they wish.