Planning for ACA Penalties in Early Retirement -Action Economics

The Affordable Care Act (ACA) also referred to as Obamacare, created a system where health insurance premiums were based on income. Within this system there are two major cliffs, at 200% of the Federal Poverty Level and at 400% of the federal poverty level. These cliffs matter to everyone, but as especially important to early retirees. These cliffs are economic cliffs where earning 1 more dollar can cost thousands in increased insurance costs.

The 200% Cliff

The 200% cliff is based on cost sharing subsidies for the deductible and out of pocket max. Most people in retirement will be over this cliff. For a couple in 2026 200% of FPL is $42,300, my concentration in this article will be on the 2nd cliff.

The 400% Cliff:

This cliff is actually a bigger deal than the 200% cliff because it directly relates to the amount of premiums an individual will pay. For people below the 400% of FPL threshold their insurance premium is limited to 8.5% of their adjusted gross income. For people earning over 400% of FPL their premium is no longer limited based on income and they must pay the full sticker price. This was temporarily changed during Covid and from 2021 – the end of 2025 people earning over 400% of the FPL still were limited to the 8.5% of income for their insurance premiums.

The biggest problem here is that the ACA effectively killed the private marketplace and premiums have expanded massively since its inception.

For a household of two people 400% of the federal poverty level is $84,600. People earning more than this amount will no longer have their insurance premiums limited by a subsidy from the federal government. The individuals will have to pay 100% of their stick price insurance premiums. This gets really tricky because since these policies were discounted for the last 4 years people have gotten used to the lower prices and planned their lives around them.

How to plan for the cliff:

In this scenario, let’s assume a $2,000 per month sticker price premium for a couple who earn over $84,600 per year ($84,600 is 400% of FPL for a 2 person household).

If they earned $84,400 per year with the 8.5% threshold, their premium is limited to $598/mo. This is a difference of $1,402 per month or $16,824 per year with only a $200 increase in yearly earnings.

Assuming this couple is retiring at 55 and needs to provide for their own insurance until 65 (for Medicare eligibility), then the total added cost is $168,240. Needing an additional $16,824 per year in income using the 4% rule would require saving an additional $420,600 in retirement accounts, however since this expense only exists for this couple for a decade, they would really only need to save the $168,240 separately in an account with plans to fully draw down that spending outside of the 4% rule.

YIKES.

Option 1: Plan to need under $84,600 in income:

Sounds easy right? The best moves for this are to do things to reduce the largest expenses people tend to have prior to hitting retirement, while still covered by an employer plan. By staying below the 400% of FPL line we can keep insurance premium costs pegged at 8.5% of income.

Pay off the mortgage: The average American spends 33% of their after tax income on housing. Having a paid off mortgage and only needing to cover taxes, insurance, and maintenance will make a big difference.
Pay off newer vehicles: The average American spends 17% of their after tax income on housing. Preferably have a newer vehicle with high MPG.
Replace furnace with a 96%+ AFUE furnace
Invest in a grid tied solar panel system

Without a house payment or a car payment it is much easier to live off of $84,000 of total income.

Option 2: Stagger high withdrawal years:

If we accept that in SOME years we will be over the threshold, it makes sense to be WAY over the threshold in those years and use that income to provide for subsequent years. For example, if you expect to spend $100,000 a year for ages 55, 56, 57, and 58, then for age 55 withdrawal $164,000. For this year you will fall off the cliff. Spend $100,000 plus the additional $16,000 in premiums in year 1, then for the next 3 years only withdrawal $84,000 of income and spend the additional $16,000 of income taken out at age 55. This will save 3 years of the $16,000 ACA penalty.

There is nothing magical about the $164,000 amount either. The standard deduction for a married couple is $32,200 and the 12% bracket goes up to $100,800, so up to $133,000 can be taken out before hitting the 22% tax bracket. The next marginal bracket isn’t until $211,400, so with the standard deduction the couple would be safe in the 22% bracket with up to $243,600.

This isn’t a spot to be penny wise and pound foolish either and worry too much about going into the 22% tax bracket. In the above scenario the couple will have $31,000 of income in the first year taxed in the 22% bracket, giving a tax bill of $6,820 for that income. If this income were across 2 years then it would all be in the 12% bracket, saving $3,100 in total taxes across those 2 years…BUT would result in paying the additional $16,000 ACA penalty in the 2nd year. It is WAY better to pay an extra $3,000 in taxes in a year than to have to pay an extra $16,000 the next year.

Worried about missing out on investment growth? After withdrawing the money from your retirement accounts, put them inside of a taxable brokerage account. The principal won’t count as income when taken out and only the subsequent gains will count as income.

Option 3: Live off of money that isn’t income:

I highly suggest developing an after tax portfolio or real estate portfolio long before retiring. The problem with traditional retirement accounts is that 100% of the money taken out of them is categorized as income. This is not the case for selling real estate or selling shares inside of a normal brokerage account.

Roth Accounts: Roth accounts, if the distribution is “qualified” do not count as income towards ACA calculations. This generally means for withdrawals after age 59 1/2. IF taking withdrawals prior to age 59 1/2 using an SEPP, then withdrawals following the SEPP guidelines would also count as qualified and not be considered income for the ACA calculations.

If I paid $50,000 for a house and sell it for $75,000, then I would only have “income” of $25,000 in the year I sold it, even though I received $75,000 in cash. The same with stocks in a brokerage account. If I paid $20,000 for stocks when I bought them and I sold them for $45,000, then only the $25,000 difference would be a gain.

Rental Income also shields significant “income” from being recognized as “income” on the federal tax return. Real estate gets the “phantom expense” of depreciation that offsets the rental income. Say I have a house that cost me $200,000 and the land was worth $20,000. I can depreciate the $180,000 house part of the real estate over 27.5 years. This gives a yearly deduction of $6,545, even though no expense is incurred in that year. If after all other expenses I received $12,000 in rental income, then due to depreciation, only $5,455 would be seen as actual income.

Option 4: Keep working with reduced hours:

Under my current employer plan to cover myself, my spouse, and 1 child I am paying $220 per month for a bronze plan with a family deductible of $4,000 and a max out of pocket of $12,700. This would be even cheaper as an individual. This is a $21,360 difference from the $2,000 sticker price for the ACA we used as an example earlier.

Scaling into retirement is often a better strategy than “all or nothing”. It may make sense for a couple that has been working a combined 80 hours a week drop down to 1 person working 30 hours a week. 30 hours per week is generally the threshold required to get employer provided insurance. Often this type of situation has an outsized effect on stress level. That 25% reduction in hours can often reduce stress by over 50%.

During a year or two of 1 spouse working 30 hours per week to maintain health insurance coverage, use this time to also implement Option 2 and take out additional income from retirement accounts in order to have high income years prior to full retirement, so that fitting under the 400% FPL will be achievable in future years.

Is it full retirement, no, but reducing total work hours by 62% is a movement in the right direction.

Option 5: Pay the Cost Anyways:

Don’t fully respond to short term incentives. Plan ahead to spend the money. Have your life budgeted for spending $2,000 a month on insurance premiums. Does it suck? yeah. Hopefully other changes will occur and health insurance plans, especially for non smokers who aren’t obese will become much more affordable.