New 5-year TIPS auctions with a real yield of 1.732%, highest in 15 years

Still, real yield was lower than expected as inflation expectations surged higher.

By David Enna, Tipswatch.com

The Treasury’s offering of $21 billion in a new 5-year Treasury Inflation-Protected Security resulted in a mixed bag for investors: The real yield of 1.732% hit a 15-year high and was quite positive, but that yield was a bit below market levels right up to the auction.

This is CUSIP 91282CFR7, and the auction result set its coupon rate at 1.625%, the highest coupon rate for any TIPS of this term since an originating auction on April 24, 2007. Buyers paid an adjusted price of about $99.48 for about $99.98 of accrued value and interest. This TIPS will have an inflation index of 0.99982 on the settlement date of Oct. 31.

This is the first 4- to 5-year TIPS auction to result in an adjusted price below $100 since April 26, 2010. The price means than a person who bought $10,000 in par value for this TIPS paid about $9,948 for about $9,982 in accrued value, plus a very small amount of accrued interest, about $7.

So all in all, this is a very positive result for investors. It’s baffling, though, that the Treasury had estimated the real yield of a 5-year TIPS at 1.89% at yesterday’s market close, and the most recent TIPS of this term had been trading all morning on the secondary market with a real yield of about 1.85%.

One factor is that inflation expectations seemed to surge higher, which would indicate strong demand for this TIPS, even though the bid-to-cover ratio was a mediocre 2.38. At yesterday’s market close, the Treasury estimated the five-year inflation breakeven rate at 2.46%, but this auction resulted in a breakeven rate of 2.67%. That’s a big move higher and would explain a lot of the gap between yield and expectations.

Also interesting is that non-competitive bids — made by small investors like us — totaled $256 million, nearly double the bids of $131 million for a new 5-year TIPS issued in April. But that surge higher probably had zero effect on a $21 billion offering.

Here is the trend in the 5-year real yield since the beginning of 2020, showing the remarkable surge higher after the Federal Reserve announced tightening intentions in March 2022:

Inflation breakeven rate

With a 5-year Treasury note trading at 4.40% at the auction’s 1 p.m. close, this TIPS gets an inflation breakeven rate of 2.67%. As I noted earlier, the 5-year inflation breakeven rate has been lingering around 2.45% for several days. A 22-basis-point jump is quite a move, and it indicates that investor demand for inflation protection is increasing.

Here is the trend in the 5-year inflation breakeven rate since January 2020:

Reaction to the auction

Source: Yahoo Finance

Over the last year, we’ve had a lot of upside surprises at the close of TIPS auctions, but this one was the reverse. While the real yield of 1.723% was a 15-year high and very attractive, it came in a little below expectations. (My expectations, anyway.) As you can see in this chart, the net asset value of the TIP ETF, which holds the full range of maturities, actually declined after the auction’s close at 1 p.m. That indicates higher yields.

And now, at 1:48 p.m., the real yield of the most recent TIPS traded on the secondary market has surged to 1.91%. Doesn’t make a lot of sense. I’ll look around for a logical explanation, but I don’t expect to find one. The bond market can humble you. It’s always a good reminder: never assume anything.

But I refuse to be disappointed with my purchase of a 5-year TIPS with a real yield at a 15-year high of 1.732% and a coupon rate also at a 15-year high of 1.625%. That’s a significant real yield after nearly a decade of ultra-low yields. And it means, most likely, that this TIPS will earn a return that will beat inflation, after taxes, if you are holding it in a cash or traditional tax-deferred account.

From today’s Reuters report:

“(T)he U.S. Treasury auctioned $21 billion in five-year Treasury Inflation-Protected Securities, with the high yield of 1.732% stopping short of the expected rate at the bid deadline, which suggested increased demand.

“Analysts said demand was fueled by strong participation from direct bidders. According to investment bank Jefferies, direct bidders took down 17% of the auction, which is about six percentage points higher than the average of the last four auctions. In dollar terms, Jefferies said this is the biggest takedown since December 2019.

FYI, the Treasury defines direct bidders as: “Non-Primary dealer submitters bidding for their own house accounts.” And another worthless definition, from Investopedia: “Direct bidders include primary dealers, hedge funds, pension funds, mutual funds, insurers, banks, governments and individuals.” Doesn’t that include just about everyone? More research is needed.

CUSIP 91282CFR7 will be reopened at auction on Dec. 22, 2022. Here’s a history of auctions of this term since 2017, showing the long string of negative real yields, including the record low real yield of -1.685% just one year ago.

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Inflation, Investing in TIPS | 73 Comments

Get ready: This week’s 5-year TIPS auction is a ‘unicorn’

Rarely seen: High real yield, high coupon rate, discount to par value.

Update: New 5-year TIPS auctions with a real yield of 1.732%, highest in 15 years

By David Enna, Tipswatch.com

The U.S. Treasury on Thursday will offer $21 billion in a new 5-year Treasury Inflation-Protected Security, CUSIP 91282CFR7. This auction will be so unusual in so many ways — based on the last decade of TIPS auctions — that I am calling it a “unicorn,” rarely seen and rarely captured. But here it comes.

Just how unusual? Let’s take a look:

  • This TIPS is likely to generate a real yield to maturity of about 1.80%, the highest for this term since October 2008, when a reopening auction got a real yield of 3.270% amid the depths of the U.S. financial crisis.
  • One year ago — one year! — a new 5-year TIPS was auctioned with a real yield of -1.685%, the lowest in history for any TIPS of any term. That is an incredible 348 basis points lower than Thursday’s likely result.
  • The coupon rate could end up being 1.75%, which would be the highest for this term since April 2007. In fact, the last 12 new and reopening auctions of this term have had coupon rates of just 0.125%. No TIPS auction of any term has had a coupon rate at 1.75% or above since a 30-year auction in February 2011, more than 11 years ago.
  • This new TIPS will have an inflation index of 0.99982 on the settlement date of Oct. 31, which means it is highly likely to have an adjusted price of less than or close to $100 par value. That hasn’t happened for a new issue of this term since April 2010.
  • The reason the adjusted price could drift slightly above $100 is accrued interest, which has been negligible through all those auctions with 0.125% coupon rates. Investors will be purchasing 16 days of accrued interest on the settlement date of Oct. 31. If the coupon rate is 1.75%, accrued interest would be about 7 cents per $100, which could cause the adjusted price to rise slightly above $100. But this isn’t accrued principal or par value, and the interest will be returned to the investor at the first coupon payment on April 15, 2023.
  • The auction size of $21 billion is the largest in history for a 5-year TIPS. In October 2019 the Treasury offered $17 billion in this term, which rose to $19 billion in 2021 and now $21 billion in 2022. That’s an increase of 24% in auction size in three years.

So, what’s not to like? Thursday’s auction of CUSIP 91282CFR7 is likely to generate a historically high yield, with a high coupon rate, at a lowish cost to par value. Meanwhile, the Treasury is pumping up the size of the offering, which should help keep the real yield high. (But I always note: Things can change.)

Definition: The “real yield” of a TIPS is its yield above official future U.S. inflation, over the term of the TIPS. So a real yield of 1.80% means an investment in this TIPS will exceed U.S. inflation by 1.80% for 5 years. If inflation averages 2.5%, you’d get a nominal return of 4.3%, pretty much on par with a nominal U.S. Treasury. But if inflation averages 4.5%, you’d get a nominal return of 6.3%.

Things can change by Thursday, but if the real yield holds at 1.80%, the coupon rate would be set at 1.75% and the unadjusted price would be somewhere around $99.75 for $100 of par value. But, because the inflation index is less than 1.0, the adjusted price will probably be something like $99.75 for $99.98 of accrued value (par value would remain at $100). All of this is a rough estimate, and that doesn’t include the accrued interest. The key is that investors at Thursday’s auction will be paying slightly less than par value.

For the buy-and-hold-to-maturity investor, this TIPS is a prize. The term is short. Sure, yields could continue rising higher, but you will have locked in a historically strong real yield over the next five years.

Here is the trend in 5-year real yields over the last 13 years, showing that the current real yield has surpassed the highest level of the Federal Reserve’s last tightening cycle, which peaked late in 2018. It’s a bit ominous, though, to see how quickly real yields declined in 2019 when the Fed changed course:

Click on the image for a larger version.

Inflation breakeven rate

With a nominal 5-year Treasury note now yielding 4.25% (which I think is attractive, by the way) a 5-year TIPS currently would have an inflation breakeven rate of 2.45%, which seems reasonable at a time when U.S. inflation is running at 8.2%, and only inching lower over the last two months. Historically, though, that is a high number and would indicate that a 5-year TIPS is expensive versus a nominal Treasury. Here is the trend in the 5-year inflation breakeven rate over the last 13 years:

Click on the image for a larger version.

This trend-line chart ends on Thursday, Oct. 13, the last day Fred had data. But the breakeven rate popped 10 basis points higher on Friday, possibly influenced by the release of a University of Michigan report on consumer attitudes. That report found U.S. consumers expect inflation to run at 2.9% over the next 5 years, up from 2.7% last month.

As the chart shows, however, market expectations of 5-year inflation have fallen fairly dramatically from a high of 3.59% on March 25, 2022. In span of 2009 through the post-pandemic surge higher in March 2020, the previous high was 2.45% on April 19, 2011, matching today’s number. Back in April 2011, U.S. inflation was running at 3.2%, versus 8.2% today.

Yes, I think a nominal 5-year Treasury yielding 4.25% is attractive, but I would still rather invest a 5-year TIPS with potential for a decent return, along with insurance against unexpectedly high inflation in the future. (Unexpected inflation is what we are experiencing today.)

Final thoughts

Unless market conditions change dramatically in the next few days, CUSIP 91282CFR7 is going to be an attractive purchase. If the real yield to maturity holds at around 1.80%, it has a 180-basis-point yield advantage over the U.S. Series I Savings Bond, if both are held for five years. But the TIPS lacks the I Bond’s sexy 9.62% annualized return for six months — I Bonds get that advantage because they track trailing inflation numbers. Nevertheless, over the next 5 years, this TIPS is likely to out-perform an I Bond with a fixed rate of 0.0%.

If you are considering investing in this TIPS, remember that things can change. You can track the Treasury’s estimate of the real yield of a full-term 5-year TIPS on its Real Yields Curve page, which updates after the market close each weekday. Non-competitive bids at TreasuryDirect must be placed by noon Thursday. If you are putting an order in through a brokerage, make sure to place your order Wednesday or very early Thursday, because brokers cut off auction orders before the noon deadline. I’ll be posting the results soon after the auction closes at 1 p.m. EDT.

Thursday’s auction will be the first of four consecutive monthly auctions that are likely to be very attractive:

  • Oct. 20, new 5-year TIPS
  • Nov. 17, 10-year TIPS reopening
  • Dec. 22, 5-year TIPS reopening
  • Jan. 19, new 10-year TIPS

And of course, on January 1, you can again purchase I Bonds up to the $10,000 per person limit.

Here is a history of recent 4- to 5-year TIPS auctions, showing the long string of recent auctions with a coupon rate of 0.125%. Thursday’s result should be much higher:

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in I Bond, Inflation, Investing in TIPS | 77 Comments

Ignore the fixed-rate drama; buy I Bonds in October

The 9.62% annualized rate for six months is a huge advantage.

By David Enna, Tipswatch.com

Here we are, in the U.S. Series I Savings Bond’s “limbo fortnight,” a period when we know the current composite rate (9.62% annualized, good for six months for purchases through the end of October) and also the upcoming variable rate (6.48% annualized, good for purchases in November through April 2023).

What we don’t know: Will the Treasury raise the I Bond’s fixed rate on November 1? And does holding out for a higher fixed rate makes sense? Let’s try to figure this out. But first, some details about the I Bond, a security that earns interest based on combining a fixed rate and an inflation rate.

  • The fixed rate will never change. Purchases through October 31, 2022, will have a fixed rate of 0.0%. The fixed rate is essentially the “real yield” of an I Bond, the amount its return will exceed future inflation.
  • The inflation-adjusted rate (often called the variable rate) changes each six months to reflect the running rate of inflation. That rate is currently set at 9.62% annualized. It will adjust to 6.48% annualized on November 1, 2022, for all I Bonds, no matter when they were purchased. The starting month of the new rate depends on the month you purchased an I Bond.

Will the fixed rate rise?

I have been arguing that the I Bond’s fixed rate should rise, since real yields of 5-year and 10-year Treasury Inflation Protected Securities are now highly positive, 1.83% for the 5 year and 1.63% for the 10 year. In fact, the 5-year real yield is now higher than at any point since the financial crisis of 2008. That’s a 14-year high. The I Bond’s fixed rate should be reset higher. I’ve suggested a range of 0.3% to 0.5% … not unusual. The I Bond’s fixed rate was 0.5% during the Fed’s last tightening cycle from November 2018 to November 2019, when TIPS yields were much lower.

However, most people in the I Bond community believe the Treasury will hold the fixed rate at 0.0% because of the unprecedented demand for I Bonds in 2022. Investors will keep buying I Bonds into 2023, drawn by that variable rate of 6.48% for six months. The Treasury doesn’t need to sweeten the pot.

So, it could go either way. I am still saying there’s a 50/50 chance we will see a higher fixed rate at the Nov. 1 reset.

Should you hold off buying I Bonds on the chance of a higher fixed rate?

If we knew for certain that the fixed rate was going to rise, I’d say “sure, this decision is a tossup.” But we don’t know anything for certain. People intending to hold the I Bond for 20 to 30 years would find a higher fixed rate very appealing, if they get it. But people intending to use the I Bond as a short-term cash holding — 2 or 3 years, for example — would clearly be better off buying in October.

And for most other people, too, I’d suggest buying in October.

Why? Buying in October gives you six months of 9.62%, the highest composite rate in the I Bond’s history. After that, you’d get 6.48% for six months. The combination of rates, when compounded, will give you an annual return of about 8.2%. If you buy in November, you are certain to get 6.48% for six months, and then a new variable rate beginning in May. You might, or might not, get the addition of a higher fixed rate.

Starting off with a rate of 9.62% gives the October buyer a huge head start over the buyer in November, especially if the fixed rate stays at 0.0%. That’s interest of $481 in the first six months, which will continue to compound higher as long as you hold the I Bond. Keep in mind that a fixed rate of 0.5% equates to $50 a year on a $10,000 investment, before compounding. It will take 8 years to catch up with the October buyer, even if the fixed rate rises to 0.5%. If the fixed rate stays at 0.0%, the buyer in October is the eternal winner, because the November buyer can never catch up.

Here are the numbers I am using, based on gradually declining inflation rates over the next 12 years. I addition, I am using a simpler form of compounding than the I Bond’s actual “pseudo-compounding,” so these numbers are a bit lower than reality.

This chart has been updated and corrected based on feedback from readers.

The key takeaway from this chart is that after 5 years, when you can sell the I Bond with zero penalty, the October buyer would have built up $12,370 versus $12,277 for the buyer in November with a 0.5% fixed rate, and $11,979 for the buyer in November with a 0.0% fixed rate.

Even after 7 years, the buyer in October is slightly ahead of the buyer with the 0.5% fixed rate. In year 8, however, the buyer with the 0.5% fixed rate moves ahead, and would stay ahead for the remainder of the I Bond’s 30-year term. So that’s why I say if we knew for certain that the I Bond’s fixed rate was rising to 0.5%, this decision would be a tossup. But since we don’t know, I recommend buying in October.

Update: #Cruncher, a Bogleheads numbers whiz, did a more exacting analysis of this breakeven equation, and found the November purchase with a 0.5% fixed rate would overtake an October purchase in 7.5 years, not 8. Here is his explanation.

As Columbo says: “One more thing

If the fixed rate rises in November, all I Bond investors will be able to nab it after January 1, when the purchase cap of $10,000 per person per year resets. So if the fixed rate does rise, we all win.

Confused by I Bonds? Read my Q&A on I Bonds

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Cash alternatives, I Bond, Inflation, Savings Bond | 49 Comments

September inflation report sets I Bond variable rate at 6.48%; Social Security COLA rises to 8.7%

Annual core inflation hits 6.6%, a 40-year high. This isn’t good news for financial markets.

By David Enna, Tipswatch.com

Here is it, the most important Inflation Day of the year, setting in stone the inflation-adjusted variable rate on U.S. Series I Savings Bonds, plus determining the Social Security cost-of-living adjustment for payments beginning in 2023.

So, what happened? All-items inflation rose 0.4% in September on a seasonally adjusted basis, and is now running at 8.2% year over year, the Bureau of Labor Statistics reported. Both of those numbers where higher than consensus estimates, meaning this inflation report could roil the stock and bond markets. Core inflation was 0.6% for the month and 6.6% year over year, also higher than estimates. At 6.6%, core inflation is now at a 40-year high.

I’ll get back to the inflation report, but let’s first dig in to the big news of the day.

New I Bond variable rate

Investors in Treasury Inflation Protected Securities and I Savings Bonds are interested in non-seasonally adjusted inflation, which is used to adjust principal balances for TIPS and set future interest rates for I Bonds. For September, the BLS set the inflation index at 296.808, an increase of 0.22% over the August number.

For TIPS, this means that principal balances will be increasing 0.22% in November, after falling 0.04% in October. For the year ending Nov. 30, TIPS balances will have increased 8.2%. Here are the new November Inflation Indexes for all TIPS.

For I Bonds, the September report was the last of a six-month series that will set the I Bond’s new annualized variable rate, which will go into effect for I Bonds purchased from November 2022 to April 2023. Inflation increased 3.24% over that period, so the I Bond’s new variable rate will be 6.48%, annualized. Here are the numbers:

All I Bonds, no matter when they were issued, will get the 6.48% variable rate for a full six months. The starting month will depend on the month the I Bonds were originally purchased. Investors can still purchase I Bonds in October and receive a full six months of the current rate, 9.62%, and then six months of 6.48%. That creates an annual return of 8%+ for a very safe investment.

The one question lingering out there is “Will the Treasury raise the I Bond’s fixed rate at the November 1 reset?” I think the Treasury should raise the fixed rate, but it’s a tossup on whether that will happen. Most I Bond experts think the rate will stay at 0.0%.

My recommendation is to load up on I Bonds in October. If the fixed rate rises in November, you’ll be able to purchase a new allocation of I Bonds in January, up to $10,000 per person per year, and benefit from the higher fixed rate.

A recent Wall Street Journal headline suggested that I Bond interest rates were about to “come down to Earth,” but no, 6.48% is an extremely attractive interest rate in October 2022. I Bond investors should continue holding this investment through the six months of 6.48%, annualized. The rate is the third highest in the 24-year history of the I Bond.

Confused by I Bonds? Read my Q&A on I Bonds

Social Security COLA

The September inflation report was the third of three — for July to September — that will set the Social Security Administration’s cost of living adjustment for 2023. The SSA uses a three-month average of a different index, the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), to set its COLA.

For September, the BLS set CPI-W at 291.854, which produced a three-month average of 291.901, an increase of 8.7% over the same average for 2021. That means the Social Security COLA will be 8.7% for payments beginning in January. That increase actually outstrips overall U.S. inflation, which has increased 8.2% over the last year. Here are the numbers:

This will be the fourth-largest increase in the history of the Social Security COLA, which was first launched in 1975, and a large bump higher than last year’s 5.4% increase. And for the second year in a row, the Social Security COLA was higher than official U.S. inflation, 8.7% vs. 8.2% for the September to September period. Here’s a look back at the COLA’s history:

The Social Security Administration says the average monthly benefit for U.S. retirees is $1,666, so an 8.7% increase will raise that monthly benefit to $1,811, or about $145 a month. If you are in the Social Security “limbo” period — older than 62 but not yet taking benefits — your future benefits will also climb by this percentage.

In addition, Medicare costs will be falling in 2023 for most retirees, with a typical person paying about $63 a year less for Part B coverage.

September inflation report

Once again, we get a starkly negative U.S. inflation report, with both all-items and core inflation coming in above consensus estimates. And this happened even though gasoline prices fell 4.9% in September, a trend that seems to have reversed in October.

Today, at 7:55 a.m., the S&P 500 futures were up 36 points. Now, one hour after the inflation report was issued, the S&P index is down 68 points, about 2%. The real yield of a 5-year TIPS on the secondary market has soared to 1.95%, up about 15 basis points this morning.

The BLS noted that “increases in the shelter, food, and medical care indexes were the largest of many contributors” to the higher all-items inflation. Again, this is evidence of inflation spreading throughout the U.S. economy, even as the economy seems to be slowing. Key findings from the report:

  • The food index continued to rise, increasing 0.8% over the month as the food at home index rose 0.7%. Food at home prices have increased an astonishing 11.2% over the last year.
  • The index for fruits and vegetables rose 1.6% in the month.
  • Gasoline prices fell 4.9% over the month following a 10.6% decrease in August, but remain 18.2% higher than a year ago.
  • Shelter costs increased 0.7% for the month and are up 6.6% over the last year. The rent index rose 0.8% in September.
  • The medical care index jumped 1% in September and is up 6.5% for the year.
  • Costs of used cars and trucks fell 1.1% in the month, but remain 7.2% higher over the year.
  • Apparel costs also fell, down 0.3%.

The BLS noted that core inflation — which removes food and energy — rose 6.6% over the past 12 months, the largest 12-month increase in that index since August 1982.

What this means for interest rates

Federal Reserve officials have been taking very public hawkish positions on future interest rates, and this inflation report backs up their words. Until inflation — especially core inflation — begins to fall toward the 4% range at a minimum, the Fed will have to stick to the plan: Raise short-term interest rates to about 4.5% and keep them there. But so far, core inflation continues moving in the wrong direction, as shown in this BLS chart:

From this morning’s Wall Street Journal report:

“Inflation has built up a lot of momentum over the last year,” said Bill Adams, chief economist at Comerica Bank. “That’s going to keep inflation higher than the Federal Reserve wants it for at least a couple more months—if not a couple more quarters.”

In addition, here are some thoughts from inflation guru Michael Ashton:

“We keep waiting for a clear turn in inflation, and it hasn’t happened yet. … That being said, and while 75bps is pretty much cemented now at the next Fed meeting, I still think that the FOMC is looking for reasons to slow the pace of hikes. Things are starting to break around the world, and there’s no appetite (I don’t think) to test the limits of the system’s fragility right now. But the balance sheet is going to continue to shrink slowly, and that’s a big part of the decline in market liquidity.”

Today’s turmoil in the stock and bond markets is another reality check: The Fed isn’t likely to back down from tightening. Higher interest rates are coming, in the near term at least. The Fed has to maintain its credibility.

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Feel free to post comments or questions below. If it is your first-ever comment, it will have to wait for moderation. After that, your comments will automatically appear.

David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Federal Reserve, I Bond, Inflation, Investing in TIPS, Savings Bond, Social Security | 30 Comments

Good news: Medicare costs are going down for 2023

Why? The Medicare system is making amends for an ill-advised increase of 14.6% in 2022.

By David Enna, Tipswatch.com

One year after Medicare costs jumped 14.6% because of uncertainty over an Alzheimer’s drug, the Centers for Medicare & Medicaid Services has announced Medicare costs will be falling in 2023 for the Part B premiums and deductible, along with declines in potential IRMAA surcharges for people with higher incomes.

The reductions are welcome news, and come at a time when U.S. inflation is running at close to a 40-year high. The CMS announcement came a month earlier than usual, which was a surprise. In about a month, if you are on Medicare, you will get a letter from CMS informing you of these new premium and deductible costs for 2023.

If you planned poorly, you may be meeting up with the Income-Related Monthly Adjusted Amount, also known as IRMAA. And you really don’t want to meet IRMAA. Even though the surcharges are going down, they can be lofty, so it’s smart to plan ahead to limit these costs.

Let’s dive into the key Medicare changes for 2023.

Part A: Hospital insurance

Most people who reach age 65 go on Medicare Part A, even if they are still working. Medicare Part A covers inpatient hospital, skilled nursing facility and some home health care services. About 99% of Medicare beneficiaries do not have a Part A premium since they have at least 40 quarters of Medicare-covered employment.

Although coverage is generally free, Part A has some sizable deductibles and coinsurance costs, and those will be rising 2.8% in 2023, making this area an exception to Medicare’s price reductions:

Keep in mind that most people on Medicare have a Medigap or Medicare Advantage plan that will cover all or most of the Part A deductible and coinsurance amounts. For example, all standardized Medicare Supplement (Medigap) plans, A through N, provide coverage for Part A coinsurance, and most also cover all or most of the Part A deductible costs.

Part B: Medical insurance

Medicare Part B can be described as covering “outpatient services,” things like doctor visits, some lab tests, an annual wellness exam, flu shots, diabetes screenings, etc. Medicare Part B generally pays 80% of approved costs of covered services, and you pay the other 20%. Some services, like flu shots and a wellness visit, may cost you nothing.

Part B deductible. Before Medicare pays anything, you have to meet your Part B deductible each year. For 2023, that deductible is falling to $226, a decrease of $7 (3%) from the annual deductible of $233 in 2022. All currently-offered Medigap plans do not cover this deductible. But once the deductible is met, Medicare and Medigap plans will cover some or all of your Part B costs.

Part B premium. The Part B monthly premium, paid by all people on Medicare, will be $164.90 for 2023, a decrease of $5.20 (3%) from $170.10 in 2022. CMS provided this explanation for the cost reduction for the Part B deductible and premium:

The 2022 premium included a contingency margin to cover projected Part B spending for a new drug, Aduhelm. Lower-than-projected spending on both Aduhelm and other Part B items and services resulted in much larger reserves in the Part B account of the Supplementary Medical Insurance (SMI) Trust Fund, which can be used to limit future Part B premium increases.

In addition, CMS announced a change in Medicare policy for people who are immunosuppressive and no longer eligible for full Medicare coverage:

Beginning in 2023, certain Medicare enrollees who are 36 months post kidney transplant, and therefore are no longer eligible for full Medicare coverage, can elect to continue Part B coverage of immunosuppressive drugs by paying a premium. For 2023, the immunosuppressive drug premium is $97.10.

Summary. For most people in 2023, Medicare Part B is going to cost $164.90 a month for the premium, plus the cost of the $226 deductible. That’s a total cost of $2,205 a year, down from $2,274 for 2022, a reduction of about 3%.

But beware … IRMAA is lurking

Since 2007, a beneficiary’s Part B monthly premium is based on reported income, known as MAGI, or modified adjusted gross income. According to the Social Security Administration handbook, for Medicare’s purposes MAGI is adjusted gross income (line 11 of the 2021 federal income tax form) plus tax-exempt interest.

Here are the 2023 Part B total premiums for high-income beneficiaries, which apply to income reported on your 2021 tax return:

These income-related monthly adjustment amounts affect about 7% of people with Medicare Part B. And it’s important to note that people on Medicare Advantage plans continue to pay the Part B premium, and are also subject to the IRMAA surcharges.

CMS just recently announced these 2023 IRMAA levels, but they are triggered by income you reported on your 2021 federal tax return. These charges are universally misunderstood. They are called 2023 IRMAA levels, but apply to the 2021 tax return. In other words, when you filed your 2021 return earlier this year, you could not know the income levels that would trigger the surcharges. And a tiny mistake can be very expensive.

When you file your 2022 return next year, realize that you won’t know the relevant IRMAA levels until October or November 2023, many months after you have filed. It’s a crazy system.

Part D: Drug coverage

IRMAA surcharges also apply to Medicare’s Part D premiums for drug coverage. There is no “standard” Part D premium — the cost you pay depends on the Part D insurer and plan you choose. The IRMAA cost, if any, is added on top of your base premium. People in Medicare Advantage plans don’t pay a separate Part D premium, since those plans include Medicare Advantage Prescription Drug (MAPD) coverage. But Part D is built into Medicare Advantage, and the IRMAA surcharge still applies.

Here are the Part D IRMAA levels for 2023, based on reported income for 2021:

IRMAA can pack a wallop

The IRMAA penalty isn’t a “progressive tax” that ramps up as you go over an income level. Instead, going $1 over the limit is the same as going thousands of dollars over the limit, and incurs the same surcharge. For 2023, the IRMAA surcharges are falling about 3.1% across the board, while the income triggers are increasing about 7.7% (except for the two highest levels, which stayed the same). That’s good news, but you still need to watch out for IRMAA.

Here is a look at the annual costs of Parts B and D, plus IRMAA, for 2023, based on income reported for 2021:

In all cases, the IRMAA cost levels will be a bit lower in 2023 — assuming the income level stayed the same — because of the Part B premium reductions. Part D surcharges remained about the same. For example:

  • A single filer with income of $122,000 would pay about $3,321 annually, versus $3,402 last year. That’s a reduction of about 2.4%.
  • Joint filers with income of $245,000 would pay $6,624 for two people on Medicare, versus $6,804 last year. That’s a reduction of about 2.7%.
  • Even a couple with income of $800,000 would pay a bit less — $16,078 for two people on Medicare, versus $16,541 last year, a reduction of of about 2.8%.

My advice: Recognize IRMAA and plan for it

It’s worth noting that the first IRMAA tier for both singles and couples is not too daunting. It adds just $937 to the annual costs for a single filer, and $1,874 to the annual costs for a couple. But the next tier up starts to get pricey, increasing annual costs by $2,356 for a single filer and $4,711 for joint filers.

So I think people looking to take capital gains, buy a boat, make Roth conversions, etc., could feel comfortable in hitting that first IRMAA tier. In fact, anyone planning on doing major Roth conversions over a period of time should probably shoot for that level, but not higher, if possible.

Anyone reaching age 63 this year, and everyone already on Medicare, should be paying careful attention to income levels each year. That means tracking capital gains distributions, dividends, pension payments, annuity income, Roth conversions, IRA withdrawals, Social Security income, etc. It’s a lot of work, but can avoid financial pain.

Another key consideration is that Required Minimum Distributions are required from traditional tax-deferred accounts beginning at age 72. If you have sizable holdings in these accounts, you could be facing years of higher Medicare premiums triggered by RMDs. And if one spouse dies, and the surviving spouse inherits tax-deferred holdings, the problem magnifies. The surviving spouse now will file a single tax return, pushing IRMAA costs much higher.

So making some Roth conversions, within reason, before reaching age 72 makes good financial sense. Plus, it’s wise to use tax-deferred accounts for charitable giving, beginning at age 70 1/2, when qualified charitable distributions are allowed.

You can appeal an IRMAA ruling

The Social Security Administration has very specific rules that will allow you to get a waiver of the IRMAA surcharge, if you meet certain criteria for a “life-changing event,” which include:

  • Work stoppage
  • Work reduction
  • Employer settlement payment
  • Death of spouse
  • Divorce
  • Loss of pension income

You’ll need to fill out IRS Form SSA-44 to request the waiver.

Conclusion

The decline in Part B costs was anticipated because of last year’s aggressive increase based on an Alzheimer’s drug that ended up costing less, and being used less, than expected. The result: A typical person on Medicare will be paying about $63 a year less for Part B coverage. Overall costs could end up rising, however, if premiums for Part D and Medigap plans increase in the coming year.

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David Enna is a financial journalist, not a financial adviser. He is not selling or profiting from any investment discussed. The investments he discusses can be purchased through the Treasury or other providers without fees, commissions or carrying charges. Please do your own research before investing.

Posted in Medicare, Retirement, Social Security | 14 Comments