By Ken Waltzer

When I meet with clients to discuss retirement planning, paying for healthcare is one of their biggest worries. No wonder: Healthcare expenses are the second or third largest retirement expense. By late retirement, healthcare costs can become the largest expense, eclipsing even housing. And this doesn't even consider long-term care expenses, which can take spending to an entirely new level.

As a former physician who was both clinician and administrator, I know more than a little about the healthcare system and how much things cost. Oddly, most physicians do not, causing many patients to pay more than they should for care. Here we will review several issues that you should consider when estimating future healthcare costs, how to pay for them and how to reduce them. There won't be space to go into detail here, but in future articles, I will address these in much more depth.

How Much Will Healthcare Cost?

First, let's look at how to estimate your own retirement healthcare costs. You can start with your expenses today and do some extrapolation, but if you're much younger than 65, there may be little relation between your spending today and what you might spend at age 80. However, if you currently have a higher-cost chronic condition, you should start with these costs as a baseline.

For the rest of us, it makes sense to start with averages and adjust up or down depending on your current and anticipated health status. For this, we're just talking about medical care -- doctors, hospitals and medications -- not long-term care such as nursing homes and home health aides, which needs to be a separate calculation.

According to a recent study by Mercer Health and Benefits, a medium-risk 65-year-old woman can expect to spend between $3,200 and $6,600 a year on health insurance premiums and out-of-pocket medical, dental and vision costs. (Framing costs on an annual basis rather than as a lump sum helps avoid sticker shock.) These costs can be expected to rise over time at more than the general rate of inflation, but also because people typically need more medical care as they age.

Your health status has a major impact on your healthcare spending. A woman with a low-risk health profile can expect her annual costs to be about 15% lower, while a high-risk individual might see annual costs of nearly twice this, and even 5 times higher in some years.

One piece of good news about healthcare costs is that as they increase with age, other expenses tend to go down as we spend less on travel, eating out, entertainment, etc. According to the Mercer study, total spending declines in later retirement, even as healthcare spending takes up a progressively larger percentage. Effective planning for healthcare costs can thus enable you to spend more on other things and leave a larger estate for your heirs.

Long-term care costs are an entirely different animal. First, unlike medical spending, not everyone needs long-term care. Second, while these expenses can be very high and poorly covered by insurance, they are usually concentrated into a limited number of years. Third, a large proportion of long-term care expenses are paid out of pocket rather than from insurance: 72% of long-term care users pay at least some expenses out of pocket.

Keep in mind how variable the costs can be: from $0 for informal care provided by a spouse or other relative to an average of $92,000 per year for a private room in a nursing home. Women, be aware that you are more likely to need long-term care than men. It's not that men are healthier (far from it): men are more likely to have a living spouse who can care for them, while women generally outlive their male spouses.

Health Insurance

For most medical care, insurance pays the bulk of the cost. Medicare is the insurance of choice for people over 65 because it is comprehensive and inexpensive. But there are gaps in Medicare's coverage that are best filled either by a Medigap insurance plan or a Medicare Advantage (HMO) plan. Which one to choose depends on a host of factors, including your own medical needs, where you live and which doctors are covered by the available plans.

Drug costs can be significant for many people. Medicare Part D provides coverage for medications, but has significant weaknesses and may not be the best choice. In some cases, Medicare Advantage can provide better drug coverage, and this will affect your decision to enroll in it rather than purchase a Medigap plan.

For my clients, dental care expenses have been much higher in some years than medical care. Dental insurance is available for retired individuals, as are dental discount plans. In addition, many Medicare Advantage plans offer dental (and vision) coverage. By the time you retire, you should have a good idea of your dental health and decide how important dental insurance coverage is likely to be for you. In any case, don't overlook this potentially expensive area of healthcare.

Long-term care coverage is the bane of both financial planners and their clients. Good private policies are becoming progressively more difficult to find and more expensive, while many people with existing policies are seeing their premiums skyrocket. Fortunately, there are many other options for insuring the costs of long-term care, including hybrid life insurance/long-term care policies, second-to-die life insurance, and Medicaid planning. There are even some private long-term care policies that coordinate with Medicaid, allowing for reduced premiums. How to choose among these many confusing options will be the subject of a subsequent article.

Building a Healthcare Nest Egg

The simplest way to save for retirement healthcare costs is to estimate your needs and add this to your retirement budget. You or your financial adviser can then run projections that includes this additional expense. For medical care, the estimate should include the cost of insurance premiums and all likely out-of-pocket expenses expressed as an annual number and adjusted for healthcare cost inflation. For greater accuracy, add an inflation factor that accounts for increasing medical expenses are you age, offset by reduced spending on other items.

Under the above scenario, saving for healthcare costs looks the same as saving for any other expense. But there are specialized vehicles to keep in mind for funding healthcare. One that I encourage clients to use whenever possible is the HSA (Health Savings Account). An HSA combines features of 529 college savings plans with IRAs. You get a tax deduction in the year when you fund the plan and the earnings grow tax-free (like an IRA). If you use the money for eligible medical expenses, the withdrawals are also tax free, as with a 529 plan. Should you not have sufficient eligible medical expenses, you can withdraw funds for general use and pay ordinary income tax (like an IRA). Or you can leave it to your spouse, who can continue to enjoy tax-free withdrawals for medical expenses.

To fund an HSA, you need to purchase an "HSA-compatible" high-deductible health insurance plan. Unfortunately, such plans are not always available. But if you can find one, I say go for it. Remember, though, that these plans almost always result in significantly higher out-of-pocket costs than traditional plans. Many people use the money from their HSA to pay these costs. I don't recommend this. Instead, pay these costs from other sources and invest the HSA account in a growth portfolio. When you turn 65 and are covered by Medicare, use the HSA account, which by now could be quite large, to fund healthcare expenses not covered by insurance. You'll have had the benefit of compound growth during the years you were funding the HSA and you'll never pay tax on this money.

Saving for long-term care is entirely different; I'll talk more about it in a subsequent article. The key thing to remember now is that good Medicaid planning can often enable you to get high-end care paid for partly by the state. For example, in many states, IRAs and other retirement accounts are excluded from your assets in determining Medicaid eligibility, helping some non-impoverished people benefit from this program.

Spending Less on Healthcare

There are ways to lower your healthcare expenses. The largest out-of-pocket medical expense for retirees is medication, yet doctors rarely know what different medications cost. Asking your doctor about alternative medications that accomplish the same goal at lower cost may encourage him or her to think about price in their medication selection. For many common diseases, there is more than one medication that can get the job done, and lower cost options can save you a lot of dough.

Contrary to popular belief, declining health in later years is not inevitable. Lifestyle plays a huge role in your health, and it's never too late to take up healthy behaviors. Doing so has become more important than ever: in years past, unhealthy habits led to an early demise, but today they are likely to result instead in progressive disability with all the associated costs.

Living healthier can also lead to a more active retirement with less down time from illness and lower likelihood of needing long-term care. You'll have more time and ability to do what you enjoy, plus the bonus of lower spending on healthcare. You may be wondering what actions to take to improve your health and keep your money out of the healthcare system.

While healthcare expenses during retirement can add up to a big number, there are many ways to fund them without breaking the bank and even ways to reduce these costs.

About the author: Ken Waltzer, M.D., MPH, AIF, CFA, CFP, is co-founder and managing director of KCS Wealth Advisory, LLC, a registered investment adviser based in Los Angeles with over $200 million in assets under management. He has worked full-time as a wealth manager since 2004, having previously been a practicing physician and medical entrepreneur. He started studying finance and investing for his own account in 1975 and has managed other people's money since 1997. Ken realizes that investing, like medicine, is both science and art. He combines the latest in capital markets theory with behavioral finance, informed by the insight and intuition that comes from 40-plus years of active investing. As in the doctor-patient relationship, he aims to help each client understand his or her financial prescription and stay on track toward a healthy financial future.