Long-term care insurance (LTCi) is an important element of good retirement planning, since it offers financial protection against unexpected illness or disability that would otherwise eat into savings. However, many LTCi plans are simply too expensive for most retirees or people nearing retirement age, and the costs just seem to be going up.
At the same time, the cost of medical care and assistance over a long period is even higher, and an unexpected illness could wipe out everything you’ve saved. You may not have enough after-tax dollars to pay for LTCi, but you can protect your retirement income by using money from your IRA to fund coverage.
Is It Possible to Avoid Taxes and Early Withdrawal Penalties?
Typically, withdrawals or non-qualified investments (including insurance purchases) made with IRA funds before the age of 59½ are subject to taxes and penalties. Certain allowances are made if you use IRA savings to pay for medical expenses that exceed 10 percent of your adjusted gross income, or if you’re unemployed and using these funds to buy medical insurance.
Although these exemptions don’t apply if you’re buying LTCi directly with your IRA savings, there are some indirect options available that allow you to avoid taxes and penalties. Here are two: fund a 20-pay life insurance plan or a qualified Health Savings Account (HSA) with part of the money saved in a traditional IRA. Both options can be done penalty-free before age 59 ½
Option 1: Convert Your IRA into LTC Insurance with a Tax-Qualified Annuity
If you invest in a tax-qualified annuity that makes internal distributions to an insurance carrier, you can indirectly pay for long-term care coverage using IRA money without additional tax penalties. Here’s how the process works:
- Step 1: Apply for 20-pay life insurance with LTC features
Apply for a 20-pay life insurance plan with an LTC rider, which can accelerate the death benefit to pay for long-term care. This policy will be funded with tax-qualified annuities that make annual distributions to the insurance policy over a 20-year period. After you apply, complete the underwriting process, and receive approval, you will be given a quote for the annual premiums required for this plan. The premiums may be higher than those for term insurance, but limited-pay plans offer lifetime security.
- Step 2: Apply for IRA-based annuity plans to fund the policy
The second step is to determine the up-front cost of an IRA-based annuity where the annual dollar amount of income is the same as the insurance premiums, over a period of 20 years. Apply for this annuity type and include instructions for the company to directly credit your 20-pay life insurance plan with the annual gains from the annuity.
- Step 3: Use a direct transfer of IRA funds for annuity premiums
Directly transfer funds from your IRA to purchase your 20-year annuity. By paying an equal dollar amount directly into your life insurance policy, this annuity will fund your insurance coverage and keep it active for 20 years, after which the LTCi policy is paid in full.
You will receive IRS tax form 1099-R from the annuity company every year on the amount of taxable IRA money moved into the life insurance policy. While you still pay income tax on this amount, the payout and benefits from the policy will be tax-free for you and your beneficiaries. After you’ve made premium payments over a 20-year period, the death benefits will apply for your entire lifetime.
Option 2: Move IRA Funds into an HSA with LTC Benefits
You’re allowed to make a one-time tax-free transfer of IRA funds into a qualified HSA, which provides tax-advantaged savings for health care expenses in the future. Check if your HSA includes an option for long-term care, and consider this method only if you meet the eligibility rules.
The maximum transfer allowed is the same as the HSA contribution limit, which in 2017 is $3,400 for single people and $6,750 for families, with an additional $1,000 in catch-up contributions for those aged 55 and up. Remember, this limit will decrease based on how much you move from your IRA. You may also be liable for taxes and penalties if you’re no longer eligible for the HSA within 13 months from December 1st of the transfer year.
The amount saved by these strategies will vary depending on the individual’s or family’s needs, the amount transferred and the expense of the annuity applied for. But they are worth the trouble, in most cases; anytime you can use tax deferred dollars, it is a good thing.
If you want to be financially comfortable, safe and happy after you retire, it may be time to take another look at your IRA savings and investment portfolio. A self directed IRA might be your best option, since you retain full control over investments. Consult a professional advisor if you want to learn more about how it works.
Rick Pendykoski is the owner of Self Directed Retirement Plans LLC, a retirement planning firm based in Goodyear, AZ. He regularly writes for blogs at MoneyForLunch, Biggerpocket, SocialMediaToday, NuWireInvestor and his own blog for Self Directed Retirement Plans. Email firstname.lastname@example.org or visit www.sdretirementplans.com.