Long-Term Care

Long-Term Care Insurance — Tax-Free Income When You Need It

The overriding goal of retirement income planning is to generate sufficient after-tax, inflation-adjusted income streams to match projected expenses during different stages of retirement. Although this can be quite challenging due to all of the unknown variables, there’s one situation where it’s possible to match the timing of the income stream to the expense, and, furthermore, do so with tax-free income.

The Need for Extended Care Planning

The situation to which I’m referring is extended care. Extended care is the least understood and most under-planned for life event. According to a Robert Wood Johnson Foundation 2014 study, less than 8% of Americans have long-term care insurance. According to the study, 43% of people needing long-term care are under 65. In addition, four in ten people turning 65 will need long-term care for two or more years.

When it’s needed, extended care takes its biggest toll on family and friends in the absence of an extended care plan.  Studies have shown that providing extended care for an individual who is chronically ill can have a devastating effect, both emotionally and financially, on caregivers.

When planning for extended care, there are several unknowns. These include the type, timing, and duration of the event. These factors will in turn determine the location where care is provided, who will be providing the care, and the associated expense. All of these elements combine to lend itself to an insurance solution, in this case, long-term care insurance.

The Role of Long-Term Care Insurance

Although it’s relatively expensive and is subject to sizable potential premium increases, long-term care insurance is designed to pay for assistance or supervision you may need in two situations:

  • Inability to perform basic activities of daily living, or ADLs, as a result of a chronic illness including bathing, dressing, eating, continence, toileting, and moving in and out of bed, or
  • A severe cognitive impairment such as Alzheimer’s disease and irreversible dementia

Care can be provided in one’s home or in a variety of other extended care settings as needed. Like all types of insurance, you can decide how much of the risk that you want to absorb vs. the amount that you want to cover using private insurance.

In addition to relieving family members and friends of the emotional and financial burdens of caregiving, long-term care insurance provides a tax-free income stream to pay for extended care when care is needed after satisfying an elimination period which is typically 90 days. The amount of coverage will depend upon the type, location, and duration of extended care as well as the benefits included in the insured’s policy.

Potential Financial Hardship

The lack of long-term care insurance when extended care is needed will be disruptive at a minimum to a retirement income plan. It will create a financial hardship in many cases. Unplanned liquidation of assets for an unpredictable length of time will be needed to pay for ongoing care.

Given the fact that most people have liquid assets tied up in qualified retirement plans such as 401(k) plans and traditional IRAs, distributions from those plans to pay for extended care will generally increase one’s income tax liability. As an example, you may need to withdraw $80,000 from taxable retirement plans to pay for $50,000 of extended care.

In addition to income tax liability, timing of distributions and liquidity of assets can be problematic. Long-term care expenses need to be paid when incurred no matter how the stock market is doing. Illiquid assets such as business interests, limited partnerships, rental properties, and personal residences can’t be relied upon to provide readily available funds to meet extended care needs.

Financial Sacrifice for Long-Term Peace of Mind

The purpose of all insurance, including long-term care, is to provide readily available funds to pay for the expenses associated with an insurable event. Given the fact that an insurance carrier’s potential risk when it comes to extended care is sizable, long-term care insurance policies are generally pricey, especially when purchased after age 55.

The cumulative premiums paid for long-term care insurance, however, are often a fraction of the cost of an extended care event. The peace of mind derived from knowing that (a) tax-free income will be available to cover extended care expenses when needed without disruption or financial hardship to a retirement income plan and (b) family members won’t be relied upon to perform caregiving services is invaluable.

Given this reality, the evaluation of the need for long-term care insurance should be an essential part of every retirement income plan.

By Robert Klein

Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.