By Hans Scheil
Seventy percent of Americans that are expected to need long-term care services at some point in their life, according to the U.S. Department of Health and Human Services. Unfortunately, when people need care, they are not prepared, especially for the financial impact. This is the danger in denial; you could be put in a facility you don't approve of, your family can be put through unnecessary pain and confusion, and you could lose your life savings. There are many ways to avoid this, with one of the most tax efficient being the use of a traditional IRA.
There are really four paths to take when paying for long-term care (LTC); three are some type of insurance.
- Short-Term Care Insurance: Short-term care insurance is exactly what it sounds like: insurance to cover a short time of long-term care, usually around a year. These policies are great for people with small budgets or people who cannot qualify for more traditional policies. This policy is a gift for your family when a long-term care crisis hits as it gives them at least a little bit of time to figure out how to pay the bill and get everything in order.
- Traditional Long-Term Care Insurance: This type of insurance is the most well-known. It covers multiple years of care. These policies can be expensive and hard to qualify for. They also can have rising premiums, resulting in a lot of people dropping the policies. However, traditional long-term care insurance is still the best option in certain cases.
- Hybrid Long-Term Care Insurance: This is the newest type of insurance and is increasing in popularity. These policies combine life insurance and long-term care insurance. If you never need long-term care, it will solely be a life insurance policy, paid out to your beneficiaries when you die. If you need long-term care, payments for these services are paid out of the death benefit. The hybrid plans are one of the more flexible options.
The last way to pay for long-term care costs is self-insurance. While many people like to believe they are going to self-insure, there is a big difference between "self-insured" and "planned self-insured". Having a plan in place is a crucial part of this option. You and your beneficiaries must know where to take the money out to pay the bills; otherwise it could cost you and then a lot of money, time, and stress. This is where IRAs come in. There is a way to pay the long-term care bill with an IRA that reduces taxable income to almost nothing, making a traditional IRA like a tax-free account.
Planning for self-insurance: If self-insurance is the chosen route, the plan put into place is going to vary by client. Generally, the plan is going to start with the clients Social Security check, as well as any other consistent income, such as a pension. For example, say Ellen has a Social Security check of $2,000 a month, $24,000 a year. According to the latest Genworth Cost of Cary Survey, the national median cost for a nursing home is almost $8,000 a month. This is going to be $96,000 a year. That leaves Ellen with a gap of $72,000. This is where an IRA will come into play, closing this cash-flow gap in a tax efficient way.
Medical expense Deductions: The strategy behind using an IRA to pay for long-term care costs takes advantage of the medical expense deduction. This deduction survived tax reform but did get some small changes. Previously, seniors could deduct medical expenses which exceed 7.5% of their adjusted gross income, or AGI; everyone else could deduct anything above 10% of their AGI. In the new tax bill, the 7.5% is extended to everyone. This has been retroactively applied to 2017 and is set to expire in 2019, when it will rise to 10% for everyone.
IRS Publication 502, Medical and Dental Expenses, explains the itemized deduction for medical and dental expenses that you claim on Schedule A (Form 1040). There is a specific section on how deductions apply to LTC costs. This section states, "You can include in medical expenses amounts paid for qualified long-term care services and premiums paid for qualified long-term care insurance contracts." It goes on to define both qualified long-term care services and qualified long-term care contracts.
There is also a specific section on nursing homes. This section says, "You can include in medical expenses the cost of medical care in a nursing home, home for the aged, or similar institution, for yourself, your spouse, or your dependents. This includes the cost of meals and lodging in the home if a principal reason for being there is to get medical care."
From these two sections in IRS Publication 502, it begins to become clearer on exactly how IRAs are going to be using to pay for long-term care and nursing home services.
Putting it all Together
With Publication 502 naming long-term care expenses as allowable medical costs, the next step is figuring out which account to take this money from that will provide the greatest tax advantage. A traditional IRA will utilize money in the most effective way. Taking the full amount needed to cover qualified long-term care costs from this account will result in your adjusted gross income and your deductions almost canceling each other out. This basically turns that IRA into a tax-free Health Savings Account.
Let's look back at the earlier example. Ellen needs to cover her $72,000 income gap, most of it going to cover her long-term care costs. When she pulls that from her IRA, her AGI is going to be $96,000 (Social Security benefit + IRA withdrawals). Since currently she can deduct qualified medical expenses which exceed 7.5% of her AGI, her deduction becomes $88,800, meaning her taxable income is reduced to $7,200 (7.5% of $96,000). The majority of the money being used to pay LTC costs is now with untaxed dollars.
Remember this strategy will only work with a traditional IRA, as the money goes in tax-free and must be taxed upon withdrawal. With a Roth IRA, the money goes in after taxes are paid, meaning money is tax free on withdrawal. If the money is tax free, it will not count towards your adjusted gross income, meaning you won't get the deductions.
While many advisers recommend taking money from taxable accounts first to cover long-term care costs, this usually does not take into account the tax advantages and the client's beneficiaries. Leaving behind a legacy after death is very important to many people. The way long-term care is paid for will inevitably affect how much money can be left. If you leave your beneficiaries money in a traditional IRA, this could require that your beneficiaries pay the taxes on this money when they receive it. If you leave your taxable accounts instead, current law would give then a step-up in basis. Basically, this means that they would not have to pay taxes on that account, not even on the gains of these accounts. Leaving your beneficiaries tax-free money could have a huge impact on the amount they receive.
This strategy is not going to work for every situation, but it is worth considering, especially if you are leaning towards the self-insurance route. What will work for everyone is having an attorney prepare these four documents: a will, a financial power of attorney, a health care power of attorney, and a HIPPA release form. Among these, the financial power of attorney is especially import for long-term care planning. This form gives the designated agent the power to decide what money to use to pay for LTC costs. For this reason, it is important that the agent is brought into the planning before he or she is needed, as they will need to know the steps to take.
Another important strategy that needs to be discussed is Veterans Aid and Attendance. This program provides long-term care benefits for veterans who qualify. The benefit is as much as $1,794 per month or $1,153 per month for a surviving spouse. A VA accredited attorney can help you figure out if you're eligible for this benefit as well as apply. It is important to know that attorneys cannot charge to help you fill out the forms for this benefit, though they can charge if other things need to be done to get your estate in order.
As you can see, there are many strategies to pay for long-term care costs, with some involving IRAs. The importance of having a plan for these costs cannot be stressed enough, if not for you, for your family. Having a plan can eliminate, or at lease minimize, the fear, anxiety, and pain that your family members will experience when a long-term care crisis hits. Make sure to consult a qualified adviser when making decisions about these plans as well, they will be able to help you find the one that will best fit your personal situation.
About the author: Hans Scheil, CFP is the CEO and owner of Cardinal Advisors in Cary, N.C. and the author of the The Complete Cardinal Guide to Planning for and Living in Retirement and the accompanying workbook. He is the host of the podcast Finishing Well. He is also a member of Ed Slott's Elite IRA Advisor Group. For more information about this group, or to find a member near you, visit IRAHelp.com.