How to Factor Medical Expenses Into Your Retirement Plan

Scott Holsopple

The word "retirement" has pleasant connotations. It's a life phase rooted in the American psyche. Workers look forward to it for years. After 40 or more years of the daily grind of work-life, in retirement we get to relax and do what we want -- be it travel, hobbies or whatever else may move us.

Very few Americans imagine steep medical bills and financial stress when they hear the word -- with the possible exception of those who are nearing this life stage and are worried about paying for medical expenses. Yet, whether you realize it or not, medical care can consume a large portion of your retirement budget.

According to the Employee Benefits Research Institute (EBRI), Medicare currently covers roughly 62 percent of an individual's medical expenses. To make matters worse, EBRI says the percentage covered by Medicare could decrease in the future. With retirees' share of health care costs rising, it's more important than ever to plan for these expenses in retirement.

Unfortunately, medical expenses for older adults are often unpredictable, and it can be difficult to arrive at an exact number. Such an amount is dependent upon two relatively unknowable variables: your future health and the future of health care coverage, by Medicare or another means.

However, there are some concrete steps you can (and should) take ahead of time to prepare for medical expenses during retirement:

1. Understand some basics about Medicare.

-- Medicare is similar to a government-sponsored health insurance plan for seniors (presently defined as persons age 65 and older).

-- Seniors can currently choose whether to be covered by Original Medicare, which is broken into two primary parts (often called Part A and Part B), or a Medicare Advantage Plan. Advantage plans, which are provided by private health insurance companies, are often called Part C and can be more expensive and more comprehensive.

-- Individuals who elect Original Medicare can buy a supplemental insurance policy, called Medigap, to fill in some of the coverage differences inherent to Parts A and B. Medigap no longer covers prescription drug gaps.

-- To cover prescription drug gaps, Medicare users can pay for Part D, which is the Medicare Prescription Drug Plan.

-- There are some prescription drugs and medical services and procedures not covered by Medicare.

-- Long-term care is not covered under Medicare.

2. Estimate your healthcare costs during retirement.

-- Start with these numbers: According to a 2011 guide to health care and retirement costs from Merrill Lynch (and based on historical insurance data and actuarial predictions), the average annual out-of-pocket health care cost in 2011 for a 65-year-old in poor health and on Medicare was $4,760. For a healthy 65-year-old on Medicare, the average cost was $4,450. By age 75, the 2011 data shows a marked increase to $5,635 for someone in poor health and $5,220 for someone in excellent health. Bear in mind that these numbers are averages for people on Medicare. A senior with a chronic or long-term illness could pay a lot more out of pocket.

-- Premiums for Medicare Part B and Part D vary based on income, so add extra premium costs if you anticipate having significant retirement assets.

-- Working from these averages, adjust for rising medical costs between 2011 and your projected retirement date. There is a wide divergence of opinion among experts with regard to the yearly rate at which medical costs will increase in the future. Historically, medical costs have outpaced inflation. According to a November 2013 report, "Trends in Health Care and the Role of The Affordable Care Act," released by the White House, the average annual increase in health costs was 4.5 percent from 1965 to 2010.

3. Review your options for paying for healthcare costs in retirement.

As with other retirement expenses, there are a variety of ways to save, earn or otherwise obtain the funds you'll need to pay for medical expenses during retirement.

-- Some employers provide a level of medical coverage after retirement. If you're nearing retirement, find out whether your employer does this and, if they do, get details about the coverage. If you're not nearing retirement, you can't count on your current employer to provide health coverage during those years.

-- Plan to work part-time during your earlier retirement years so you can limit the amount you withdraw from your retirement accounts. You should also continue to save and invest as much as possible to help pay for future out-of-pocket medical expenses.

-- Integrate medical care costs into your overall retirement saving and investing plan. As with other retirement funds, you won't need all the money on day one. You can remain invested during retirement in order to grow your health care savings. Work with a financial advisor to determine the most appropriate investment strategy for you.

Despite your planning, expect there to be some unknowns related to health care costs during your retirement years. Determining how much to save should come down, in part, to your comfort level and expected medical needs based on your current health and family history. If you're uncomfortable with the unpredictable nature of future medical costs, you'll probably feel more at ease with a higher needs estimate -- a better-safe-than-sorry approach may be just what the doctor ordered.

Scott Holsopple is the president of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.