Our ACA Subsidy Strategy Got Complicated by VGSH
Our COBRA coverage expires this year. And next year, we plan to switch to an ACA insurance plan.
As mentioned in an earlier post about ACA health insurance in early retirement, we're hoping to qualify for ACA subsidies. Doing so could dramatically lower our insurance premiums.
The catch? We need to manage our household MAGI (Modified Adjusted Gross Income). It’s a major factor in determining whether we qualify for subsidies and how much we can receive.
How ironic is it that when we were working, we worried about not having enough income, and now that we’re retired, we worry about having too much?
And don’t think having no paycheck means no income. Even though we have no earned wages, we still have income in the form of interest, dividends, and capital gains.
Fortunately, we have a lot of control over some of it. We can choose how much capital gains to realize, and most of our interest comes from CDs, which makes it relatively easy to estimate.
Then there's our short-term Treasury ETF.
Its monthly distributions fluctuate, which makes our total investment income harder to predict. And getting the estimate wrong could cost us thousands of dollars in additional health insurance premiums.
THE ACA SUBSIDY CLIFF
Under the rules currently in effect, household income generally needs to fall between 100% and 400% of the federal poverty level to qualify for subsidies in the form of Premium Tax Credits. The amount of the credit decreases as income rises.
And once you're above the 400% threshold, the credit disappears under the current rules.
It’s not a gradual credit decrease after you pass that threshold. It just hits you. You’re suddenly paying full price for health insurance premiums.
That’s why it’s called the dreaded ACA subsidy cliff. And we’re trying to avoid it like Wile E. Coyote.
Of course, tax laws have a habit of changing just when you've finally figured them out. So we'll have to check the rules and applicable poverty-line amounts again when we actually enroll.
OUR RETIREMENT INVESTING AND TAX STRATEGY
Managing our MAGI would be easy if we were just spending down our savings accounts in retirement. Simply spending money doesn’t count as income.
But a huge reason why we were able to retire before 50 was that we kept nearly all of our money invested—mostly in individual stocks. And we’ll stay heavily invested to generate income.
We have, however, shifted our priorities slightly since retiring. We’re now focusing less on growing our investments and more on reducing taxes. After all, we grew our money for ourselves, not that freeloader Uncle Sam.
We’ve also started to shift some of our money into a VGSH, Vanguard’s short-term Treasury ETF.
Treasury bonds and their ETFs were something we had previously avoided. It wasn’t because they are bad. They just didn’t fit into our strategy at the time, which was to grow our net worth as quickly as possible.
Things have changed, though.
We’ve become a little more cautious about the stock market, so we started purchasing VGSH to give us some protection in the event of a market crash. Plus, it gives easy access to cash if stock prices drop and buying opportunities appear.
But these two things—our tax strategy and VGSH—make managing our MAGI a little complicated.
HARVESTING CAPITAL GAINS WHILE REDUCING RISK
When we eventually sell our stocks for more than we paid for them, the resulting capital gains may be taxable. Fortunately, because we've held most of our stocks for a long time, we'll generally be dealing with long-term capital gains rather than short-term gains. Depending on our income, that can result in a lower federal tax rate.
But to reduce taxes even further, we are harvesting as much capital gains now while staying within the 0% capital gains tax bracket. Capital gains harvesting will reduce our federal tax liability in the future, while the 0% tax bracket helps us pay little to no federal taxes now.
The one drawback to capital gains harvesting is that it raises our MAGI. Keeping our MAGI low enough to qualify for ACA subsidies means reducing our realized capital gains in any given year.
We’ll still try to harvest as much capital gains as we can. We just need to be careful not to realize too much. Fortunately, we have full control over this.
Our short-term Treasury ETF situation, though, is a little trickier.
THE PROBLEM WITH VGSH DISTRIBUTIONS
VGSH makes monthly dividend distributions, but the amount fluctuates from month to month. That's partly because the fund's portfolio changes as Treasury securities mature and are replaced, and because interest rates affect the income generated by the portfolio.
And unlike capital gains harvesting, we have no control over this.
To complicate things even more, we automatically reinvest distributions to buy additional shares of VGSH. As our shares grow in number, so do our dividend distributions over the long run.
At least that’s how it works in theory. In reality, growth has been anything but a straight line. But hey, that’s the nature of investing.
Still, this makes estimating the total annual income generated from this investment even more difficult. And underestimating the number could inadvertently push us over the ACA subsidy cliff.
HOW WE'RE GOING TO MANAGE OUR MAGI
To make estimating easier, we plan to stop the automatic reinvestment of dividend distributions.
To be clear, whether we take the VGSH distributions in cash or automatically reinvest them, the income still counts. Reinvesting the money doesn't make it magically disappear from our tax return.
That's why stopping automatic reinvestment helps us manage the investment, not eliminate the income.
But we won’t just let that cash sit in our accounts. We’ll put that money to work by investing it in shares of a low-cost ETF that tracks the S&P 500.
That ETF’s diversification will still provide us with some protection in the event of a market crash. And while it may still pay dividends, we expect the amount to be much smaller than the distributions from VGSH. We'll include those dividends in our income estimate, too.Y
To estimate the total distributions we'll receive from VGSH, we'll look up its 30-day SEC yield at the beginning of the year. Multiplying the value of our VGSH holdings by that yield should give us a rough estimate of the fund’s annualized income.
It won't be perfect since the yield and our account value can change throughout the year. But it's better than blindly guessing.
And with the estimate, we’ll have a better idea of how much capital gains we can harvest while staying within the income threshold to qualify for ACA subsidies.
To play it safe, we’ll conservatively harvest capital gains during the year. And towards the end of the year, when we have a clearer idea of how much in dividends we’ll actually receive, we may harvest a little more.
As an added buffer and to keep our health insurance premiums low, we plan to purchase an HSA-eligible HDHP.
An HDHP (high-deductible health plan) comes with lower premiums in exchange for higher deductibles. The added benefit is that some HDHPs can be paired with a Health Savings Account (HSA).
Eligible HSA contributions can reduce your adjusted gross income, which can in turn reduce the MAGI used for the Premium Tax Credit.
We’ll use this HSA to bring our MAGI back down if our investments happen to push us over the subsidy cliff. Because HSA contributions for a tax year can generally be made through the tax-filing deadline for that year, we can wait until we have a clearer picture of our actual investment income before deciding how much to contribute.
TIME TO BUILD A NEW RETIREMENT TAX SPREADSHEET
So our retirement income strategy is getting a little more complicated.
We need to estimate our VGSH distributions, carefully harvest capital gains, account for our other investment income, and leave ourselves enough room under the ACA income threshold. And if we get too close to the line, we may be able to use an HSA contribution to bring our MAGI back down.
Earlier this year, I shared the spreadsheet I created to estimate our federal tax liability based on ordinary income and long-term capital gains. I love that spreadsheet. It's fun playing with the numbers and seeing how much income we can have while owing little or no federal income tax.
Now that ACA subsidies are another piece of the puzzle, it's time for an upgrade.
Who knew I'd still be building complicated spreadsheets in retirement? At least it's not as much work as being employed.
And it's a lot more fun. Hopefully, I can share it with you soon.
See you at the finish line!
Disclaimer: I may hold shares of some of the companies mentioned. I’m not a licensed financial professional. This blog shares my personal experiences and opinions around money, investing, and early retirement. It’s for informational and educational purposes only—not financial, legal, or tax advice. Always do your own research or consult with a qualified professional before making any financial decisions.
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