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Investing Specialists

The Best Place to Save for Long-Term Care Expenses

Counterintuitively, vehicles offering tax-free withdrawals aren't always the best for long-term care savings.

The average tab for a year's worth of nursing-home care topped $100,000 last year, according to Genworth's most recent Cost of Care report, and those costs are inflating at a 4% rate. Given that the average duration of care is in the neighborhood of 2.5 years, as well as the fact that half of the population will need some type of long-term care during their lifetimes, many consumers are apt to confront some scary bills later in life.

Yet despite those daunting figures, more and more consumers are deciding to forego standalone long-term care insurance. Hybrid products that combine life insurance or annuities with a long-term care insurance rider have picked up the slack. But many other consumers are going without any sort of insurance against long-term care. People without large stores of assets will likely need to rely on Medicaid funding for long-term care, and indeed, Medicaid covers the majority of long-term care costs in the U.S. today. At the other extreme, wealthy individuals who are foregoing insurance are banking on their own assets to carry them through--and praying they won't have to.

I wrote about how to quantify the decision about whether to self-fund (not to be confused with "self-insure") long-term care costs this week. I also urged prospective self-funders to segregate their long-term care assets from the assets they expect to use for living expenses. But then a related question crops up: What's the best receptacle to use for those earmarked long-term savings? Here's a review of the key options. (Note that for the purpose of this article, I'm focusing on pure savings vehicle and setting aside various insurance products, including annuities and life/long-term care insurance and life/annuity hybrids.)

Traditional IRA
In a few key respects, a traditional IRA is the ideal receptacle for long-term care assets. Yes, withdrawals are taxable, to the extent that they consist of pretax contributions and investment earnings. But individuals incurring heavy long-term care costs often easily exceed the threshold for deductibility of healthcare expenses. (In 2018, healthcare expenses that exceed 7.5% of adjusted gross income are deductible, though that figure is moving to 10% starting next year.) That means that the deduction can offset the taxes due on the IRA withdrawal.

It's also worth noting that most long-term care costs are incurred later in life, when required minimum distributions (which apply to traditional tax-deferred accounts for people who are over age 70 1/2) apply. In other words, the money has to come out of the account at this life stage anyway, and the medical expense deduction helps to ease the tax burden. Moreover, the fact that both company retirement plan assets and IRA asset can be rolled into an IRA upon retirement allows for a significant bulwark against long-term care costs.

On the other hand, withdrawing from an IRA will tend to be less advantageous for older adults who are taking light advantage of long-term care services (for example, they're hiring caregivers to help for a few hours per week at home). In that case, their long-term care outlays may not meet the deductibility thresholds; pulling from vehicles with tax-advantaged withdrawals would be the better strategy.

Roth IRA
Even as withdrawals from traditional tax-deferred accounts can make sense during years of heavy long-term care outlays (see above), withdrawals from Roth accounts will tend to be less beneficial during those years. That's because Roth tax treatment is the reverse: taxable dollars go in and the money comes out on a tax-free basis. Thus, even though an individual's long-term care expenses might readily exceed the IRS' thresholds for deductibility of medical expenses, the Roth IRA withdrawals wouldn't be taxable, meaning that the benefit deductions would likely fall by the wayside. 

Moreover, Roth IRA assets are often the most attractive for heirs to receive, so using those assets for long-term care costs would reduce the amount of assets that would pass tax-free upon death. 

That said, Roth assets may be useful in years in which long-term care outlays don't exceed the threshold for the deductibility of medical expenses. 

Health Savings Account
With the opportunity to make pretax contributions, grow investment earnings tax-free, and cover qualified healthcare expenses with tax-free withdrawals, HSAs offer unparalleled tax benefits. Assuming the HSA boasts good-quality investment options without a lot of extra costs, the ability to take a tax break both on the way in and on the way out of the account means that HSA investors' take-home returns can be higher than investors' in traditional tax-deferred or Roth accounts. (This article discusses the topic in greater detail.) Long-term care expenses would generally be considered qualified healthcare expenses for tax-free IRA withdrawals.

As is the case with Roth IRA withdrawals, however, an HSA's tax benefits are almost too good in the context of long-term care. That's because if you withdraw from an HSA to cover long-term care costs, you can't also deduct those expenses on your tax return. Of course, that's true with any HSA deduction--to cover long-term care costs or anything else. But that foregone deduction is particularly valuable in years of heavy long-term care usage, when an individual's healthcare costs may be by far the biggest bill, easily exceeding the threshold for deductibility of medical expenses. On the other hand, an HSA may be useful in the earliest stages of long-term care, when those outlays are relatively lighter.

Additionally, as discussed here, HSA annual contribution limits may limit a saver's ability to earn critical mass with the account, especially for those who are starting later in life. (And let's be realistic: Few people start thinking seriously about the financial implications of long-term care before they're 50.) Additionally, HSAs can be costly and feature subpar investment options, though that problem can be readily circumvented, as discussed here. Finally, while HSA assets inherited by one's spouse continue to enjoy their prodigious tax benefits, an HSA inherited by someone other than your spouse won't be able to enjoy those same benefits. This would only be a problem if someone doesn't use their HSA asset for long-term or other expenses during their lifetime, though, and therefore falls into the realm of "first-world problems."

Taxable Account
Assets in a taxable account are taxed on an ongoing basis, assuming they're making income and/or capital gain distributions. And when you sell appreciated securities in a taxable account, you'll owe capital gains tax, either short-term or long-term. From the standpoint of withdrawals, taxable accounts fall between traditional tax-deferred accounts (most withdrawals dunned at ordinary income tax rate) and Roth accounts and HSAs (tax-free withdrawals). 

One feature of taxable accounts that makes them different from tax-advantaged accounts is that the taxes due upon withdrawal depend on what is withdrawn. For example, an investor could prune highly appreciated securities in years when long-term care costs are also high, thereby offsetting the taxes due upon the sale. Of course, such assets would also be appropriate to leave for heirs, who can take advantage of the step-up on cost basis upon the death of the original owner.

Ultimately, there's no single right answer; indeed, this is yet another case for tax diversification. In years of relatively light outlays for long-term care expenses, accounts offering tax-free withdrawals, such as HSAs, will be the most beneficial. In years of heavier outlays, withdrawing from vehicles that allow for the deductibility of medical expenses, such as traditional IRAs, will be the better strategy.