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.
A version of this article previously appeared on Oct. 25, 2018.
The average tab for a year's worth of nursing-home care rang in at nearly $106,000 in 2020, according to Genworth's most recent Cost of Care report, and those costs are inflating at a roughly 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. Whether they choose to receive care in an institutionalized setting is another matter: Given the tragic loss of life to the novel coronavirus in long-term-care facilities over the past year and a half, it's a good bet that more and more older adults will opt for home-based care when the time comes and if they have the financial wherewithal to do so.
Yet despite those onerous expense of long-term care, most consumers forgo insuring against long-term-care expenses: Just 7.5 million Americans had some type of long-term-care insurance in place as of 2020. People without large stores of assets will need to rely on Medicaid funding for long-term care, and indeed, Medicaid covers the majority of long-term-care costs in the United States today. At the other extreme, wealthy individuals who are forgoing insurance are banking on their own assets to carry them through--and praying they won't have to.
For the latter people self-funding long-term care--and I'm guessing a lot of Morningstar.com users fall into that camp--I like the idea of segregating long-term-care assets from the assets they expect to use for living expenses. That way, any conclusions about the retirement plan's sustainability relate to the spending portfolio, not the long-term-care portion. 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.
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 2021, healthcare expenses that exceed 7.5% of adjusted gross income are deductible.) 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 72) apply. In other words, the money has to come out of the account and be taxed 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 assets 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.
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.
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. 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 and use the funds to cover long-term-care costs, you can't also deduct those long-term-care 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, 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 may feature subpar investment options, though that problem can be readily circumvented. 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 assets for long-term or other expenses during their lifetime, though, and therefore falls into the realm of "first-world problems."
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).
Selling appreciated securities from a taxable account will trigger capital gains tax, of course, but deductions for heavy healthcare and long-term-care outlays can be used to offset the tax bill associated with the sale. Of course, such taxable assets would also be appropriate to leave for heirs, who can take advantage of the step-up in 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.