Long-Term Care Expenses Can Blow Up any Retirement Plan - How I Solved for it by Scott Stolz (week 21)

 

If you are turning 65 today, you have a 70% chance of needing some kind of long-term care service in your lifetime.  And I’m sure it will come to no surprise to you that the cost of that care is not only expensive but is growing at a rate well beyond the average cost of inflation.  Long-term care costs are a simple matter of supply and demand.  The number of senior citizens is growing every day while the number of people trained to care for them is not keeping pace.  In fact, the latest Genworth study on the cost of long-term care produced the sobering numbers below:

Even if you are able to be cared for in your home – which is almost everyone’s preference – you could be paying $75,000 per year for the proper assistance.  Sure, your kids can provide some care and therefore save you a fair amount of money, but even if they are willing and able, do you really want to put that burden on them?  Despite this likely cost, most people elect to self-insure.  Many also mistakenly believe that Medicare will cover any long-term care costs.  The reality is that Medicare does not cover most long-term care services.  For example, Medicate does not cover custodial care, which is non-medical assistance with daily activities like bathing, dressing, and eating.

As I’ve mentioned in previous blog posts, retirement planning is challenging because there are 3 things you can’t know – how long you will live, what you will earn on your savings and what unexpected expenses you will incur.  Not only is long-term care the most likely unexpected expense, but it will probably be the largest as well.  Given this, I elected not to self-insure.  In my opinion, the likely need combined with the potential size of the expense makes it just too big of a risk to my retirement income plan.

How I Solved My Own Long-Term Care Risk

A number of years ago I bought a variable universal life insurance (VUL) policy.  This form of life insurance allows you to invest your premiums in a variety of stock and bond funds.  Realizing that I was going to own this policy for a number of years, I chose the most aggressive stock funds offered by the policy.  Over time, the policy value grew enough that I could have the annual premiums deducted from the policy’s cash value rather than paying them out of pocket.  But once my kids graduated and moved out of the house, my life insurance needs were greatly reduced.  Therefore, I elected to repurpose this policy to cover my long-term care risks.

I used the $73,000 in cash value from my VUL policy to purchase a combination life insurance/long-term care policy from Lincoln National.  These hybrid policies contain enough death benefit to qualify as a life insurance policy but is really bought for the long-term care benefits attached to the policy.  In my case, I got a life insurance benefit of $160,000 as well as a total long-term care insurance benefit of almost $400,000 payable over a maximum of six years.  In addition, the long-term care benefits grow by 3% per year to help cover the cost of inflation.  And what if I’m one of the lucky ones that don’t need long-term care?  Then my wife will receive the $160,000 life insurance benefit when I die.

Another Potential Solution: A Long-Term Care Qualified Annuity

If I were asked to vote for the most underappreciated type of annuity, I would not hesitate to vote for the Long-Term Care Qualified Annuity.  This relatively unknown and obscure category of annuities was created by the Pension Protection Act of 2006. 

Most long-term care qualified annuities are essentially fixed annuities.  However, there are several important differences:

1. Unlike traditional annuities, any money withdrawn from a long-term care qualified annuity to cover long-term care costs is not taxable.  It comes out of the contract completely income tax free.  I’ll bet that grabbed your attention. 
2. Because the primary goal is to provide the most possible long term care coverage, most long-term care qualified annuities pay minimal interest each year.  Instead, the insurance company gives you a multiple of your initial investment in long-term care benefits.  For example, you might buy a contract with $100,000 and have $200,000-$300,000 of available funds to pay for long-term care expenses.  Rather than adding interest to your account each year, the insurance company essentially provides you a pool of funds to use for long-term care expenses – all completely income tax free.

In many ways, this type of annuity is similar to the hybrid long-term care life insurance policies described above.  In both cases you deposit money into the policy.  If you have a long-term care expense, the insurance company will first pay your expenses out of the money in your policy.  The insurance company does not start paying your long-term care expenses out of its own money until you have exhausted your own funds.  Essentially, their hope is that if your expenses are greater than the money you deposit into the policy, they can make enough money over the years on the money in the policy to cover those additional expenses.  Remember though, the goal here is to create a pot of money that is available to cover what could be a very large, unknown expense.  And what if you don’t have any long-term care expenses?  Then the value of your annuity will be paid to your beneficiary. 

Using an Annuity You Already Own

In my case, I repurposed an existing life insurance policy to by the Lincoln policy.  But what if you have a non-qualified annuity (one outside of a retirement account) that you’ve owned for years, and you don’t anticipate needing for retirement income?  This is where a long-term care qualified annuity can really shine.  Eventually, either you or your beneficiaries will have to pay taxes on the income that has accumulated without taxation within that policy.  However, the tax code allows you to exchange one annuity for another without creating any taxes.  Such a transaction is called a 1035 tax-free exchange.  While a long-term care qualified annuity has different tax-treatment when used for long-term care expenses, it’s still an annuity.  Therefore, it too can be purchased with the proceeds from another annuity.  That means if you someday have long-term care expenses, you could tap all of your already earned tax-deferred income completely income tax-free.

Let’s look at an example.  Let’s assume you bought an annuity 10 years ago with a $50,000 premium.  Over the years, that annuity has grown and is now worth $100,000.  You have no long-term care coverage, and you don’t want to have to worry about this potentially large and unknown expense in retirement.  You therefore exchange your existing annuity for a long-term care qualified annuity.  This $100,000 may buy you as much as $250,000 in long-term care coverage.  This means you now have a $250,000 pot of money you can access income tax free in the event you need it.  The only thing you have given up is the potential growth on the $100,000 that you used to buy the policy.  Granted, if you live long enough the growth you gave up might be substantial, but you’ve covered a highly likely and potentially very large risk. 

If your financial advisor has not talked to you about long-term care and you have an existing life insurance or annuity policy that you no longer need, ask him or her about these hybrid policies.  If your advisor is not familiar with either of them, get another advisor.