If you’ve been a good saver and have built up a tidy nest egg to support your retirement years, my guess is that the vast majority of those dollars are in a pre-tax retirement account, such as an IRA or a 401(k). Our tax code incented you to save into these pre-tax accounts by giving you a tax break on the amount you save each year, in exchange for your willingness to pay tax on the withdrawals, many years down the road. By the time retirement rolls around, your account balance is probably looking pretty good!
So here’s the rub: when you withdraw money from your IRA or 401k to pay for anything at all, you have to pay income tax on the withdrawal. Whether you’re paying for new windows on your house, or a lovely vacation or just monthly living expenses, those taxable withdrawals will end up costing you more than the cost of the item itself.
Let me give you an example: let’s say you’ve been retired for a few years and you need a new car. You want to withdraw $35,000 from your IRA to pay for your car. But that $35,000 is taxable income, and it pushes you into the next higher tax bracket – from your current 12% bracket to the 22% bracket. It’s easy to do a calculation and think you’ll need an additional $7,700 ($35,000 times 22%) to pay the tax. But ACTUALLY, you need even more than that because you also have to pay income tax on the $7,700 tax withdrawal itself. What?? Remember that every dollar out of an IRA is taxable income. Crunching the numbers, you’ll actually have to withdraw $44,871 from your IRA, to have enough money to pay the 22% tax on the whole withdrawal ($9,871) leaving you with the $35,000 needed to buy the car. You can check my math: take $44,871 times 78% (100% - 22%) = $35,000 left for the car purchase.
So you actually spent $44,871 of your retirement account to buy that $35,000 car. It’s crazy but true – altogether it added 28% cost to your car purchase, simply because you had to use a pre-tax account to pay for it.
Now to the point of my article: let’s translate this logic into paying for long term care costs. According to the 2021 Genworth cost of care study, the national average cost of one month of home health care is approximately $5,000/month for 44 hours/week of care. This translates to $60,000/year. Using the same logic as my car example, you’ll have to withdraw $76,923 to cover the cost of the care and the 22% associated tax. If you needed full-skilled care, which runs about $8,000/month nationally, or $96,000/year, that withdrawal would probably push you into the next higher 24% bracket, so you’ll have to withdraw $126,315 to cover your care and the associated 24% tax on the withdrawal.
Just to add insult to injury, how much you pay for your Medicare Part B and Part D premiums is determined by your income. Adding those IRA withdrawals to your tax return each year could very well push you and your spouse into more expensive Medicare premiums.
As you can see, this is a huge downside to using pre-tax retirement accounts to pay for what may be multi-year, ever-increasing healthcare costs for you and your spouse. You’re literally paying an income tax surcharge on long term care costs, which are in and of themselves already a stunning amount for today’s retirees. This conundrum can drain your retirement account much faster than you ever expected. Trust me, I’ve seen it happen. And honestly, even if you have a significant amount of money in your IRA’s and could afford the tax surcharge, why would you want to? Why wouldn’t you look for a more tax-savvy solution and save more of your IRA dollars to leave a legacy for your kids and grandkids instead?
So where can we find more tax-efficient or even tax-free dollars to pay for ongoing retiree health care costs? Here are a few ideas, and depending on how much time you have until potential health care costs could arise, one answer may be a better fit than another:
Non-retirement investment accounts: investments held outside of your IRA/401(k) are much more tax efficient. You only pay tax on the amount of the gain of the investment you’re selling, not on every dollar you withdraw. And then that tax rate is typically 15% for capital gains. For example, if you had a $60,000 investment with a $20,000 embedded gain in it, you’d only pay $3,000 in taxes. So that $60,000 home health care bill would cost you $63,000, all-in, instead of $76,923 if you paid it out of your IRA.
Roth IRA’s: while we tend to think of these tax-free assets as legacy assets for our family since we want to keep them growing tax-free for as long as possible, if push comes to shove they’re a great source of tax-free cash flow to you. That $60,000 home health care cost would be just that - $60,000. And no worries of higher Medicare premiums either!
Asset-based Long Term Care Insurance: my personal favorite, if you are in generally good health. Why use your money to pay for LTC costs when you can use the insurance company’s? The beauty of asset-based LTC policies is that they solve the “use it or lose it” problem and the “ever increasing premium” problem of traditional LTC policies. An asset-based LTC policy is funded either one time or over 5 to 10 years, and then you’re done. The insurance company can’t come back and ask for more premium money later. It provides a guaranteed pool of TAX-FREE dollars that you can use for home health, assisted living or full-skilled care as needed. And if you never use it, it has a death benefit that goes to your heirs, also tax-free. That $60,000 home health care bill doesn’t drain your assets OR hit your tax return– since these benefits are paid by the insurance company, tax-free. And the payments don’t affect Medicare premiums.
Reverse mortgage: I have to say that I’ve come around to appreciate the flexibility that reverse mortgages can provide for retiree health care costs. Basically, it is a way to tap the equity in your home without having to move and without losing title to the house. You still own it. You can get either a lump-sum loan or a line of credit that you never repay. The principal and accruing interest is paid off when the house is ultimately sold – either at your passing or if you move to a full-skilled facility, for example. Your heirs still keep any excess value of what the home was worth over what the reverse mortgage balance was to pay it off. The reverse mortgage proceeds are tax-free to you, so once again you’re not paying an income tax surcharge nor risking higher Medicare premiums.
You can see that’s lots of nuance that goes into paying for retiree health care costs. Sure, it’s easy to just pick your biggest retirement asset – your IRA – and use it to pay for all sorts of retiree expenses But please be aware of the tax consequence to your decision. To the extent you can use after-tax or tax-free dollars, you’ll preserve your assets so that they will last longer through your retirement years and perhaps even have enough left to leave a legacy to your kids or grandkids that could forever change their own financial lives.