Risking the Nest Egg: Using Retirement Savings for Long-Term Care

The U.S. Department of Health and Human Services estimated in 2020 that 50-70% of those now turning 65 will eventually need some level of long-term care.

Yet, few people include a long-term care component in their retirement planning. It seems like more people plan for their children's college education than for the very costly and highly probable reality of long-term care. Assumptions that typically drive this lack of planning are:

Assumption Reality
Long term care will not be needed As noted above, 7 of 10 of those reaching age 65 will need some form of long-term care
Government programs like Medicare and Medicaid will foot the bill Medicare will only cover the first 100 days of care after a discharge from a minimum three-day hospital stay. Medicaid pays only after a person's assets are reduced to a certain level and/or specific medical qualifications are met.
Family will step in to provide care Even though over 37 million family members provide unpaid care to parents, it is not an option for everyone. Caregiver health problems, lack of knowledge, geographical separation, and over-taxed schedules can make this activity unrealistic for many families.
Retirement savings will be sufficient to cover the cost Those who have diligently saved for retirement with IRAs and 401(k)s may feel confident they'll have enough for any long-term care contingencies. However, this may be a risky assumption. 

Types of Personal Resources

The types of personal resources are:

This post will cover pensions, IRAs, and regular savings.

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A pension is an employee benefit providing taxable payments to a retiree that continue until the recipient dies. Social Security also falls under the pension heading, but in this case, the federal government is the payer. Social Security is a public pension, and company-sponsored plans are called traditional pensions.

Traditional pensions were common before 401(k) plans and IRAs were introduced in the 1970s. Today, only about 15% of private-sector employees are eligible for traditional pension plans. However, for government employees, 83% are eligible.

When planning for long-term care costs, pensions can be an important component because income flows from these plans become a predictable, no-risk part of a long-term care strategy.

401(k)s and Traditional IRAs: Retirement on Tax-Deferred Dollars

When it comes to retirement planning, the Baby Boom generation might also be called the IRA/401(k) generation. For example, in the last twenty years, pensions and other "defined benefit" programs have given way to "defined contribution" accounts like IRAs and 401(k)s in a big way. At the end of 2020, IRAs and 401(k)s made up almost $22 trillion in retirement savings.

Total U.S. Retirement Assets 2005 (In Trillions) 2020 (In Trillions) Change
IRAs $3.4 $12.2 +259%
401(k) and other defined-contribution plans $3.7 $9.6 +159%
Defined benefit plans (pensions) $6.0 $10.5 +75%
Annuities $1.3 $2.5 +92%

Despite this seemingly massive amount, most retirees should not assume their retirement savings will be sufficient to cover their long-term care needs.

The main reason is many Americans have not saved enough. The average amount in retirement savings in 2019 for those aged 75 or older was about $358,000, with the median amount being $83,000. (The difference in these numbers suggests individuals with larger retirement savings accounts skew the average to be higher, and therefore, most have saved considerably less than average.)

Another issue is the "tax-deferred" nature of IRA and 401(k) dollars. A big reason for the popularity of these accounts is that there are no taxes paid on initial deposits nor on the gains in value over time. The problem is, however, taxes are paid when the money is withdrawn.

To illustrate the problem, imagine Donna and Steven, Florida residents who both retired at 65 with about $750,000 in IRA money and a home worth $225,000. They assumed without much analysis that their tax-deferred retirement savings would be enough to cover any long-term care needs. Their goals were to stay in their home as long as possible and leave some inheritance for their children.

Steven passed away when Donna was 75, leaving her with $280,000 remaining in retirement savings and a home that had increased in value to $300,000.

Donna needed in-home health care starting at 75. She found a good option for $50,000 per year. (Assume for this illustration that 2021 in-home and assisted living each cost $50,000 per year with a 3% annual inflation rate for both.)

As noted above and in the chart below, she needed to withdraw about $59,000 to clear $50,000 after federal taxes to have enough money during her seventy-fifth year.

Due to the low amount of savings and the tax effect, Donna had nearly exhausted her IRA/401(k) retirement savings by age 78. As a result, she was forced to sell her home and moved to assisted living. Fortunately, due to her circumstances, she avoided paying capital gains on the home sale.

Donna then paid for long-term care from her home sale proceeds. But unfortunately, by her death at age 84, these funds were gone.

Age Long-Term Care Cost (3% inflation) Withdrawal Amount Needed Assets Balance (Dec. 31)
75 (in-home health start) $50,000 $59,000 $221,000
76 $51,500 $61,000 $160,000
77 $53,045 $63,000 $97,000
78 $54,636 $65,000 $32,000
Home sale ($300,000)     $328,537
79 (assisted living start) $56,275 $56,275 $272,082
80 $57,964 $57,964 $214,118
81 $59,703 $59,703 $154,415
82 $59,494 $61,494 $92,921
83 $63,338 $63,338 $29,583
84 $65,239 $65,239  ($35,656)

Note: At age 78, taxes on the remaining IRA money = $3,643, leaving $28,357 for spending.

This illustration is greatly simplified by assuming residence in a no-income-tax state and ignoring other expenses like supplemental Medicare insurance premiums, clothing, and entertainment, to name a few.

Donna achieved part of one goal by living at home for four years. However, she missed the second goal of leaving an inheritance. Her assets ran out during the last year of her life, and her family had to pay the outstanding $35,656 balance.

Would things have been different if Donna and Steven had planned more carefully? For instance, they could have converted some of their IRAs to Roth IRAs in the years before retirement. This way, they would have paid taxes on the regular IRAs in their working years, and the investments would have grown tax-free from then on in the Roth IRAs. (See more information on Roth IRAs in the last section below.)

Suppose this resulted in Donna having $280,000 in Roth IRAs at age 75. The result would have been much better.

Age Long-Term Care Cost (3% inflation) Withdrawal Amount Needed Assets Balance (Dec. 31)
75 (in-home health start) $50,000 $50,000 $230,00
76 $51,500 $51,500 $178,500
77 $53,045 $53,045 $125,455
78 $54,636 $54,636 $70,819
79 $56,275 $56,275 $14,544
Home sale ($300,000)     $314,544
80 (assisted living start) $57,964 $57,964 $256,580
81 $59,703 $59,703 $196,877
82 $61,494 $61,494 $135,383
83 $63,338 $63,338 $72,045
84 $65,239 $65,239 $6,806

In this scenario, Donna would have been able to live at home one year longer and leave a small inheritance.

As Donna and Steve's story shows, undertaking thorough long-term care planning could make reaching their goals more likely, especially when using tax-deferred accounts to fund long-term care.

Roth IRAs and Regular Savings

Finally, Roth IRAs and regular savings need to be considered for paying long-term care costs.

A Roth IRA differs from a traditional IRA in that taxes have already been paid on the dollars deposited in these accounts. As a result, no taxes are due when money is withdrawn from a Roth IRA, including on the increases in value over time. However, to make tax-free withdrawals, the funds must have been in the Roth for at least five years, and the account holder must be at least 59½ years old. Otherwise, a 10% penalty is payable but only on the interest and earnings.

Like Roth IRAs, deposits to regular savings and investments are made with after-tax dollars. However, unlike Roth IRAs, the interest and earnings increases are subject to either regular taxation or capital gains taxes.

A tactic that can be advantageous under the right circumstances is to convert a traditional IRA to Roth IRA. In this scenario, taxes are paid on the money coming out of the old traditional IRA, but subsequent value increases in the Roth IRA are not taxed.

All financial resources available to potential recipients must be considered for long-term care planning. Knowing the details about subjects like tax treatment and other factors is essential to build a solid plan for handling these significant costs.
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