Prepare for Care

James McGlynn

YOUR LIFE’S FINAL costly chapter may be paying for long-term care. Indeed, the odds of needing care if you’re age 65 or older are around 50%.

Two key questions: Will you need care for an extended period and how will you pay for it? If the duration is short—which it is for many seniors—paying probably won’t be much of a problem. But if long-term care is needed for many years, financial decisions today might protect the legacy you hope to bequeath decades from now.

Long-term-care (LTC) insurance can take the form of either traditional standalone coverage or a hybrid policy. It’s possible that current standalone policies, after being underpriced for many years, are now priced correctly. Still, I never wanted to make a long-term investment in a policy where premiums could jump if the insurer’s “costs” rose.

That’s why I opted for a hybrid policy that “guarantees” no increase in premiums. The company I chose for my hybrid policy hasn’t raised premiums on its hybrid LTC policies in more than 30 years, which I find encouraging.

A hybrid LTC policy is one that’s built around either a life insurance policy or a tax-deferred annuity. The basic idea: If you don’t need long-term care, your heirs will receive either a tax-free death benefit or the tax-deferred annuity. If you do need care, you’ll receive the benefits tax-free and, in some cases, the monthly benefit can be of unlimited duration. Intrigued? This is a good time to be looking. For the first time in a few years, the cost of hybrid policies has declined, thanks to rising interest rates.

When I bought my policy some years ago, I paid a large lump sum for a second-to-die life insurance policy. Yields on cash investments were incredibly low at the time, so depositing a hefty premium with the insurance company struck me as a good use for my conservative money. But as I’ve further researched hybrid policies, I’ve learned of two other funding methods that are appealing, though they’re also a little more complicated.

One method is to exchange an existing tax-deferred annuity for a hybrid LTC insurance annuity. This is an attractive way to defer the annuity’s taxable gain—and perhaps avoid the tax bill entirely. If the hybrid annuity is later used for LTC, the benefits received are tax-free. The Pension Protection Act of 2006 created this “loophole” to encourage the sale of LTC insurance.

I convinced a friend to use this strategy. He had invested $150,000 in a tax-deferred annuity that was now worth $300,000. He exchanged the annuity for an LTC annuity. If he eventually receives LTC benefits from the annuity, he’ll receive the benefits tax-free, thus sidestepping taxes on $150,000 in gains. The annuity covers both himself and his wife. Even though my friend is wealthy and can afford to pay LTC costs out of pocket, the better solution was to receive LTC benefits tax-free, especially given his high tax bracket.

Another funding option might be the most useful: buying the policy with your IRA. Tax-deferred IRA and 401(k) money is often a retiree’s largest investment. After age 59½, when the 10% early withdrawal penalty no longer applies, you might withdraw, say, $6,000 a year from your IRA to buy a hybrid LTC life insurance policy.

After 10 years of $6,000 annual payments, the policy would be fully paid up. If the policy isn’t used for long-term care, it can provide a death benefit for your heirs. To be sure, taxes will be due when the $6,000 is withdrawn each year from the IRA. But that’ll likely be more attractive than paying taxes on $60,000 withdrawn in a single year.

James McGlynn, CFA, RICP, is chief executive of Next Quarter Century LLC in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of Retirement Planning Tips for Baby Boomers. Check out his earlier articles.

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