Long-Term Care Insurance: Alternatives and Pitfalls
Long-Term Care insurance is about the most intractable problem in retirement planning. What are the alternatives to Long-Term Care insurance, and what are some of the pitfalls to avoid?
Obvious downsides to traditional Long-Term Care insurance include the use-it-or-lose it status, and the fact that policies were initially underpriced so they have undergone extensive cost increases. Will is be there if you actually need it?
Hybrid Life Insurance Long-Term Care policies are complicated and can be stuffed with gotchas.
Let’s look at Alternatives to Long-Term Care insurance and some Pitfalls to avoid.
Best Alternative to Long-Term Care insurance
Pretty obviously, if you build wealth and self-insure for Long-Term Care insurance, you have the best of both worlds. There are, after all, two possibilities: either you do or you don’t utilize Long-Term Care Insurance. And it is not as simple as the statistics would have you believe. You see the number “70% of people” will need care at some point. Yes, as we get older, many of us will need care. But how many need and qualify for reimbursable care? The answer is much lower, perhaps 5% of those with a policy.
So, finding an alternative to traditional or hybrid Long-Term care is the right answer 95% of the time.
That’s the whole point of insurance, is that you pool your risk with others. But that is not how Long-Term Care insurance is sold, which is a major pitfall of Long-Term Care insurance.
Self-Insure Your Long-Term Care Insurance Needs
So, how much do you need to self-insure for Long-Term Care Insurance?
Morningstar recently put the self-insure number above $2.5M. The title of this piece, however, is “There no magic number for self-funding long term care insurance.” Instead they suggest you:
- Gage the likelihood of needing long term care
- Ballpark the cost of care (with this document)
- Customize based upon your situation and preferences
- Think through the back-up plan
- See if you can afford it
- Segregate assets set aside for long term care from other assets
For those who don’t want to self-insure and are considering Long-Term Care Insurance, should you consider traditional insurance or a hybrid product? In order to answer that question, let’s review what is available and think a little about the pitfalls of both.
Pitfalls of Traditional Long-Term Care Insurance
Let’s start with the pitfalls of traditional Long-Term Care policies. These policies underwrite morbidity risk. They are less common now than in years prior because of premium increase horror stories. Traditional policies may be expensive given chronically low interest rates, longer life spans, and increasing medical costs. Premiums are subject to increase over time.
Premiums paid to traditional Long-Term Care Insurance are tax deductible for individual taxpayers. There is, of course, a 10% floor in 2019 that must be met to itemize these as deductions. The 10% floor is difficult to get above given the large current standard deduction. The amount of the premium that is deductible depends on your age. That is, someone in their 70’s can deduct $5270 a year, whereas someone in their 40’s can only deduct $420.
A business owner can often deduct the full amount, but this is a complex topic and depends on type of business entity. See Kitces for general refence on business deductions.
What about tax treatment of reimbursements? As with health insurance, you can exclude payments for personal injury or illness from LTCI. There is a limit, about $370 a day in qualified expenses. Payments above this are fully taxable unless actually used for long term care.
Paying Premiums from a Health Savings Account
Usually only medical expenses (rather than insurance expenses) qualify for reimbursement from health savings accounts (HSAs). LTCI premium payments, however, are in fact HSA eligible. The same aged-based limits above apply. Any amount above the limits requires after tax payment. Obviously if you use the HSA to fund premium payments, you can’t turn around and deduct the payments as this would be double dipping.
Pitfalls of Hybrid Long-Term Care Insurance Policies
Let’s move on to Hybrid LTC/Life Insurance policies.
More salesmen are pushing hybrid policies, where you get permanent life insurance with a long-term care or chronic illness rider. The riders vary in their cost. Another example is an accelerated death benefit rider. Many allow access to the cash value or death benefit if needed for LTC expenses. For example, you could get 2% of the death benefit a month in advance to pay for long term care. Or you can get, for example, 25% of your death benefit a year for qualifying costs.
For (often) a lump sum premium payment, your heirs may get a death benefit. In addition, these policies have a small amount of cash value, and a defined dollar amount of LTC benefits. Obviously, you can use only one of these three benefits. So, if you use the LTC rider or access the cash value, the death benefit either shrinks or goes away entirely.
Hybrid Long-Term Care Policies are Not READY for Prime Time
Hybrid policies are relatively expensive and in reality, don’t do anything well. The death benefit is small and may decrease with age. The cash value is low for the cost. As for paying long term care costs, traditional LTCI policies are more effective and pay more.
An advantage: premium is paid up in advance so not subject to increases.
Folks like these policies, however, because if they don’t “use” the LTC benefit (say they die in their sleep), they still get something for their money (the death benefit). All is not “lost.” Or, they can use the cash value instead, if needed.
This is a similar argument for Variable or Equity Indexed Annuities rather than single premium immediate annuities (SPIAs). With the expensive fancy annuities, you still get “something” if you die early. Of course, there are massive downsides to these annuities compared to straightforward, traditional annuities like SPIAs. Hybrid policies are like an expensive swiss army knife, when all you may need is a good old-fashioned steak knife for your dinner.
Tax Implications of a Hybrid Policy- The Largest Pitfall
Hybrid policies have significant tax shortcomings. They are not tax efficient; this is a downside most folks don’t think about. The salesmen won’t necessarily say anything about the inefficiencies: “consult with your tax advisor” is what you are likely to hear.
Premiums are never deductible.
As for reimbursement of expenses, hybrid policies pay out basis (the after-tax money you paid for the policy) first, leaving the fully taxable excess behind.
Neither of these are good features. No deduction going in, and your after-tax money coming out first.
So, in general, traditional LTC policies are more effective and more tax efficient than hybrid policies.
But we haven’t yet even discussed the most problematic feature of hybrid policies.
Should You Use your Hybrid Policy or an IRA to Pay for Long Term Care?
Think about this for a second: if you have an IRA and a hybrid policy, which would you rather use for long term care expenses? You would rather use your IRA. Really? But you bought the hybrid policy just in case you needed long term care…
So, you have long term care insurance, but you shouldn’t use it?
Exactly. See the numbers in detail below.
If your goal is to leave money to your heirs, use the Always Taxable money in the IRA to fund health care costs. Then, if health care related spending is above the 10% AGI floor—as is common in years where you have massive LTC bills—you might get a tax deduction. When you spend from the hybrid policy, there is no possibility of a tax deduction.
In addition, spending down your IRA on health care means less fully taxable income for your heirs. Thus, you save the tax-free death benefit in the hybrid life insurance policy. Your heirs would rather receive a tax-free death benefit from they hybrid policy than pre-tax income from the IRA.
So, hybrid policies are less effective, not tax efficient and even if you have one (and an IRA), you shouldn’t use it.
When might a hybrid policy be a good idea?
Using 1035 Exchanges – The Advantage of Hybrid Policies
In general, if you have old annuities or permanent life insurance, consider a 1035 exchange if you decide you want LTCI.
The advantage here: take tax-deferred growth in these products and use them for another purpose without paying the taxes.
This is especially true for an annuity which is otherwise fully taxable as a death benefit. Or, if you have tax-deferred growth in a life insurance policy, use this money tax-free to pay qualified LTCI claims after a 1035 exchange to an appropriate hybrid policy.
Again, Kitces has a great review on the topic.
Yes, 1035 exchanges are complicated. They can make sense if you have an old annuity or life insurance policy not otherwise of use. Especially consider a 1035 exchange if there is a lot of tax-deferred growth and you have a high probability of needing long term care.
The long and the short: leverage an old product into something you might have a better use for. If you do, in fact, have the need.
Annuities with Long-Term Care Riders?
Yup. There are “hybrid annuities” as well.
Usually, these are Fixed or Equity Indexed Annuities with income riders used for LTC expenses. Often, with fees and expenses, returns are zero or negative. However, they build up 2-3x the initial investment (in a fictional separate account) for LTC expenses. Of course, your premium is utilized initially and the fictional money only tapped if there are still LTC needs after your money is gone.
In reality, only consider a LTC annuity if you are in poor health. Annuities with income riders require minimal underwriting to purchase. If you die before you use the rider, you heirs get the value of the annuity. Of course, the death benefits of annuities are fully taxable. If you die while taking income, heirs usually get the initial premium minus any paid income.
Pitfalls of Hybrid Long-Term Care Insurance- What Advisors Miss
I argued above that if you have both an IRA and Hybrid Long-Term Care Insurance, you should use your IRA to pay for long-term care costs!
What, I have Hybrid Long-Term Care Insurance but it doesn’t make sense to use it? Yes! READ ON.
The Downsides of Hybrid Long-Term Care Insurance
Let’s look at a scenario and see the cons of hybrid long-term care insurance.
Assume a single 76-year-old woman has an IRA and a hybrid life insurance policy with a rider that allows access for LTC costs. For 4 years, from age 82-84, she spends $100,000 a year on long-term care costs prior to expiring.
She can use her hybrid policy to pay the costs, or the IRA.
If she uses the IRA, her heirs get a $400,000 death benefit. Of course, then they won’t inherit the IRA!
So, if she wants to leave the most money to her heirs as possible, how should she pay long term care costs?
Hybrid Long-Term Care vs. IRA: Tax Rates
Above, you can see the effective tax rates for both the hybrid long-term care insurance policy (on top) and when an IRA is tapped to fund LTC costs (on bottom).
You can see both start off with a federal tax rate just below 15%. State taxes bring it up to a 20% Effective Tax Rate.
When LTC costs start at age 82, the federal effective tax rate goes down to zero, as there are massive itemized deductions that overwhelm the income due to required minimum distributions from the IRA.
On the bottom, she takes an extra $67,000 distribution above and beyond the required minimum distribution. This “fills up” part of the 10% tax bracket which is otherwise “wasted” if the hybrid long-term care insurance policy is used for LTC costs.
Let’s see how this fills up the tax brackets.
Tax Brackets for Hybrid Insurance vs. IRA
As seen in figure 2, the tax brackets are shown for the hybrid LTC on top and when an IRA is used to fund LTC costs on bottom.
The 10% and 12% brackets are wasted when you use hybrid long-term care insurance, whereas using the IRA to fund LTC costs partially fills the 10% tax bracket.
Let’s move on to the summary
Summary: What your Advisor isn’t Telling You about Hybrid Insurance
This table is in $100k.
On the left, see the hybrid LTC policy on top. In the middle, the IRA. Finally, on the bottom, the plan that follows us “usual” recommendations for de-accumulation (brokerage account, followed by the IRA).
The first column demonstrates total taxes paid over the 4 years of LTC costs. Note that you do pay less taxes with hybrid LTC insurance. The None pays the most, as the brokerage account is decimated early which leads to a spike of fully taxable withdrawals from the IRA.
Next, see the size of the brokerage account with the $400,000 death benefit to the bottom two plans. After the final year expenses, the value is less than $400,000.
The IRA column demonstrates the value of the IRA in each plan, followed by the total amount (brokerage plus IRA).
Taxes must be paid on inherited IRAs, and for simplicity, I have assumed the heir is in the 25% or 40% tax bracket.
Note that if the heir is in the 25% tax bracket, they get 9% more money, and in the 40% tax bracket, they receive 15% more money.
Conclusion: Should you Use the IRA or Hybrid Insurance?
The answer is clear. Hybrid long-term care insurance is a less effective way to pay for long-term care costs than an IRA.
Even though you pay more in taxes with the IRA, you pay taxes in the face of usually massive health care-related deductions, which offset most of the taxes!
Use the 10 and even 12% brackets to take money out of the IRA and save the tax-free death benefit of the life insurance for heirs. They are usually in the peak of their earnings and will pay much more than 12% taxes on your tax-deferred money!
Your Advisor isn’t telling your that hybrid long-term care insurance is not tax efficient. If you have it, you probably shouldn’t use it!
The Alternatives to Long-Term Care Insurance
So obviously, having enough money to self-insure for long term care insurance is the best option. Other considerations are deferred annuities (such as DIAs or QLACs) that are set to kick in later in life and increase your guaranteed income.
Home equity via Reverse Mortgages are also an option. Actually a pretty good option for most.
Finally, there are some who must consider spending down to Medicaid.
Conclusion — Alternatives to and Pitfalls of Long-Term Care Insurance
In retirement income planning, the decision about long term care insurance is tough. Single folks and those without legacy or charitable goals are less likely to want it.
If you don’t have much, consider a partnership plan or plan to spend down for Medicaid.
If you have “enough” to self-fund or self-insure, likely more than $2.5M, the decision is more based on your individual health and personal risk preferences.
In the un-sweet spot in the middle, the choice is most difficult.
If you have an annuity or permanent life insurance policy you don’t need, a 1035 exchange to a hybrid policy is something to think about. But if you can afford one, a traditional LTC policy is better.
Most of the time, Long-Term Care Insurance is a waste of money.
Celebrate when you waste money on term life or auto insurance and don’t use it. If you have long term care insurance and don’t use it, great!
Sometimes, especially with insurance, wasting money is good.