Money saved and invested in IRAs and qualified plans can grow tax-deferred to generate income later in life. While retirees would like to enjoy the pursuits that make their hearts content, they must also expend money on physical maintenance. Besides unfortunate events and extreme longevity, healthcare is the third significant unsystematic retirement risk. It is "unsystematic" because occurrences are random and vary among individuals. This article focuses on a specific type of healthcare-related risk: Long-term Care (LTC) or extended care (i.e., when someone requires assistance over a prolonged period to perform certain activities of daily living, such as bathing, eating, and dressing).
The uncapped liability from runaway LTC expenses can adversely impact a financial plan by consuming the very assets dutifully saved and invested. Costly Care Typical expenditures in retirement usually include health insurance premiums and out-of-pocket charges for acute care.
Fidelity Investments and the Employee Benefits Research Institute have separately estimated that an average couple (age 65 and enrolled in Medicare) needs about $300,000 to cover such expenses and this excludes LTC. Researchers at New York Life counter that adequate annual income is needed instead of a lump sum, and that an average retiree's personal healthcare spending is approximately $4,500 per year. When now factoring in LTC, the published cost estimates differ based on the setting. Care delivered inside a person's residence is typically less expensive than at a nursing home.
When now factoring in LTC, the published cost estimates differ based on the setting.
Insurer Genworth calculated the 2020 national median charges for in-home care and a private room in a nursing home to be around $54,000 and $105,000, respectively. Facility costs vary by location, reflecting the local cost of real estate and have consistently grown faster than the Consumer Price Index. The federal government's data show that, on average, men and women have needed care for 2.2 years and 3.7 years, respectively. Furthermore, 20% of 65-year-olds today may need these support services for longer than five years.
Scaling the Pyramid: Where will the money come from to pay for this care?
The Investment Company Institute believes the answer is somewhere in a five layer retirement resource pyramid. While each household will hold these assets to a varying degree, financing sources (starting from the base and moving up) are Social Security, homeownership, employer sponsored retirement plans, IRAs, and other assets.
If LTC is suddenly required, Social Security income might be committed to other living expenses and home equity accessible through some arrangement. As is frequently the case, affected individuals may have little in the way of other assets. Such other assets might include health savings accounts (HSAs). HSA contributions, earnings, and distributions for health-related expenses, including LTC, are tax-free. Given the inherent restrictions and limitations around their use, HSAs could assist with LTC funding.
All that said, retirees may need distributions from qualified plans and IRAs to help pay for LTC. Tapping pre-tax IRAs and qualified plans will increase taxable income. Assuming a 24% marginal tax rate, every $1 in IRA withdrawals would net only 76 cents — less with state income taxes. (Note: For those itemizing deductions, the medical expense deduction could offset some of this taxation.)
Every $1 in IRA withdrawals can raise that year's modified adjusted gross income (MAGI) dollar for dollar. The higher MAGI can affect the income-related monthly adjustment amount (IRMAA). Medicare Part B and Part D premiums may move higher, two years later, as a result. Accessing this part of the pyramid for extended care can impact other types of healthcare-related expenses in retirement. Recognizing Risk Having identified LTC as a retirement risk, we now weigh different approaches.
It's also looking increasingly less likely to avoid steep LTC exposure as people age. The U.S. Department of Health & Human Services states that someone turning age 65 today has a nearly 70% chance of one day needing some form of LTC. For those healthy enough to qualify for LTC insurance, the risk is closer to 60% of females and 50% of males. Reducing Risk LTC is a good candidate for insurance (or pooling), because the frequency per individual is low, yet physical, economic impacts severe. Individuals differ in their risk tolerance and can respond to LTC risk (if at all) with insurance, investments, or a combination thereof. Note that exposure mitigation guides the choice of approach, which then determines the funding allocation.
Assume taxes are paid on elective (versus required) retirement account withdrawals. The net funds can now be classified as other assets, providing much more flexibility to respond in a crisis. Insurance offers additional leverage, because one dollar in premium can deploy multiple dollars in the event of a claim. While life insurance is a prohibited holding inside of an IRA, those same dollars can build an army outside of an IRA.
The April 2021 issue of Ed Slott's IRA Advisor described such pooling alternatives as LTC insurance, life insurance with linked LTC benefits, and annuities. In our practice, clients choose among these potential designs by using a fact finder combined with a decision tree. The field of options includes only a particular type of annuity or a life insurance rider that does not require underwriting for LTC when a person has trouble qualifying for insurance.
We are working with a 64-year-old married man we'll call Carl. Like many people, Carl's assets are heavily skewed towards home equity and retirement accounts.
To pool, Carl can start taking elective distributions from his retirement accounts now, before he'll face RMDs. One idea is to use a 10 x 10 strategy: $10,000 a year for ten years to purchase a life insurance policy with linked LTC benefits that are larger than the death benefit. After a decade, Carl would not pay additional premiums. The policy's LTC benefits can grow by simple or compound rates annually to help maintain purchasing power. An alternative is traditional LTC insurance, which does not require as large an initial premium outlay.
Picking a Prudent Policy
Among the choices of life insurance policies are those with LTC riders (under IRC section 7702B) and those with a chronic illness rider (under IRC section 101[g]). Coverage may differ depending on the rider chosen. Both can offer temporary (i.e., incapacitated after a knee replacement) and permanent coverage. A 7702B policy must provide specific consumer protection provisions. A 101(g) policy may allow terminally ill or chronically ill individuals to accelerate a portion of the death benefit. A 101(g) policy cannot use the term "long-term care" in its marketing.
There are different models for payment of benefits. With a cash indemnity-style benefit, the insurer pays the contractual amount. The insured chooses to save or spend the money. Under the reimbursement option, the insurer reimburses actual outlays up to a specific limit. Fortunately, advisors can individually verify the best available rates and terms for an insured individual. The process outlined above shows how life insurance product selection can move away from dueling illustrations to focusing on an individual's best interest.
The Public Option
Excluding informal care from family and friends, Medicaid is the primary payer of LTC expenses nationwide. This health care program, administered by states and designed for low-income segments of the population, now serves almost 71 million individuals — including those not impoverished.
The second derivative of LTC planning is for Medicaid itself, with maneuvers around income eligibility requirements and countable asset inclusion. There are still loopholes in Medicaid's estate recovery process. Reliance on Medicaid has also triggered concerns over access to quality care and institutional bias that directs people towards a nursing home instead of their residence.
The current Medicaid eligibility rules could be more stringent for tomorrow's retirees. Advisors will be wise to put private plans in place to deal with this unsystematic risk. Proactive use of elective retirement account withdrawals can provide the funds necessary to pool LTC risk and avoid the necessity of going into poverty to pay for LTC.
Guest Expert Ashok S. Ramji, CFP®, RMA®, LTCP, CLU®, ChFC®, RICP®, CDFA®, CAS™ TOP Planning, LLC Kirkland, WA
Securities offered through J.W. Cole Financial, Inc. (JWC) Member FINRA/SIPC. Advisory Services offered through J.W. Cole Advisors (JWCA). Franklin Planning and JWC/JWCA are unaffiliated entities. Securities are not FDIC insured or guaranteed and may lose value. Investments are not guaranteed and you can lose money. This presentation is for educational purposes only and is not an offer to buy or sell an investment. Neither Franklin Planning nor JWC/JWCA are tax or legal advisors and this information should not be considered tax or legal advice. Consult with a tax and/or legal advisor for such issues.