How to Use Your Pre-Tax IRA to Pay for Long Term Care

We previously addressed the issue of paying for Long-Term Care without Long-Term Care Insurance. In a prior post, we discussed how you can utilize your home equity to pay. 

While the strategy can offer many benefits, from the ability to stay in your home, to protecting other assets, it can also offer a way to access benefits in a tax-favorable way. 

However, some retirees are leery of choosing a reverse mortgage as an option. For those uneasy, there can be another tax-efficient way to pay. 

How One Family Chose Another Strategy 

Meet Mark and Linda Johnson, who discovered how to turn a potential financial burden into a tax-saving opportunity. Their story shows how smart planning for long-term care expenses can lead to significant tax savings—and provide peace of mind for retirement.

The Challenge: Balancing Long-Term Care Planning with Tax Efficiency

The Johnsons faced a common retirement planning dilemma: how to prepare for potential long-term care needs without breaking the bank. With $1.8 million in retirement savings (mostly in Traditional IRAs), they needed a strategy that would:

• Provide for potential long-term care expenses
• Minimize tax implications
• Avoid expensive insurance premiums
• Maintain retirement lifestyle flexibility

They also wanted to make sure they would have “something” left for their kids. However, while this is a desire, they were fully aware that their strategy to pay for long term care is the priority. 

A Tax-Focused Strategy

Their solution? Creating a dedicated long-term care fund within their existing retirement accounts. Here’s how they did it:

Step 1: The Setup

The Johnson’s did not think it was in their best interest to pursue long-term care insurance, so the focus instead shifted to maximizing current assets to construct a strategy to pay. 

The instead did the following:

• Transferred $200,000 from Mark’s primary IRA to a new, separate IRA
• Earmarked these funds specifically for long-term care expenses
• Maintained tax-deferred status through direct transfer

Since the IRA transfer was exactly that, it caused no taxable event in the year in which the transfer was made. It also allows the Johnson’s to consider the specific asset allocation of this need. Being that the remaining funds would have been utilized for living expenses and other needs, this allowed them to have some level of ease knowing a plan was now in place. 

There is still an RMD required from this account as it would have been had the accounts stayed consolidated, but it at least allowed for a separation of accounts based on needs. 

Step 2: The Implementation

When Mark needed nursing home care at age 75, their strategy proved its worth:

• Total medical expenses: $85,000
• IRA withdrawal amount: $85,000
• Annual adjusted gross income: $150,000
• Medical expense deduction threshold: $11,250 (7.5% of AGI)
• Total deductible amount: $73,750

The IRS provides guidance that long-term care expenses would be covered in the event of such an event. But rather than using after-tax sources or Roth sources which could grow more favorably and be passed to the children more favorably, they could instead utilize the accounts which have not yet been taxed. 

The Results: Significant Tax Savings

The numbers tell a compelling story:

• Initial withdrawal: $85,000
• Tax deduction: $73,750
• Tax savings: $16,225 (at 22% marginal rate)

Obviously, the higher the cost of care or the higher the marginal tax bracket, the higher the savings can be. 

This leads to additional savings beyond just the current year, however. It’s especially true in the event Mark dies and leaves the funds to Linda, who would be subject to less favorable rates at Mark’s passing. 

Those benefits include:

1. Lower Required Minimum Distributions

• Reduced IRA balance meant lower future RMDs
• Decreased future tax liability
• More control over retirement income

2. Asset Preservation

• Protected other retirement accounts
• Maintained investment flexibility
• Preserved Roth IRA funds for other needs and asset transfer

3. Financial Peace of Mind

• Clear plan for healthcare expenses
• Reduced retirement stress
• Protected overall retirement strategy

A Simple Move with Numerous Benefits

The Johnsons’ approach succeeded because it used pre-tax dollars efficiently while also leveraging medical expense deductions when the situation arised. 

But something else that came from this is the fact they didn’t have to pay for an insurance that they may or may not have needed. 

While we are advocates for proper insurance coverage, we often hear about the downsides of purchasing an insurance policy, paying sizable monthly premiums, only to not utilize or need the coverage. 

In this example, Mark needed to utilize the coverage, but had he or Linda found themselves not needing to utilize the IRA for long-term care needs, they could have had an account that would be accessible for living expenses or other needs. 

On top of that, the move gave them other benefits, such as:

1. Provided dedicated healthcare funding
2. Reduced future tax obligations
3. Maintained investment flexibility

Could This Strategy Work for You?

This strategy is certainly not feasible for everyone. But if you find yourself meeting the following criteria, it could be worth pursuing:

• Have significant Traditional IRA assets
• Want to plan for long-term care needs
• Are looking to optimize tax efficiency
• Prefer self-insuring over LTC insurance

This is not to say that Long-Term Care Insurance is not a viable option. Each situation is unique and perhaps it is right for you. 

But as you continue to age, the cost of Long-Term Care Insurance continues to rise. 

Implementation Tips

If this strategy is right for you, it may not be as complex as it sounds. The good news is that there are unlikely to be any costs associated with implementing the plan, just some time and strategizing. It is a strategy that will require some initial work up front, but also monitoring of the plan:

Getting Started

1. Review your current retirement accounts
2. Calculate potential care costs
3. Determine optimal segregation amount
4. Set up dedicated healthcare IRA

Ongoing Management

1. Regular strategy reviews
2. Documentation system setup
3. Tax planning coordination
4. Healthcare cost monitoring

As always, these plans are best when worked with the professionals in your life, such as your financial planner, tax professional, and potentially an elder law attorney. 

Conclusion

The Johnsons’ story demonstrates how proactive planning can turn a potential financial challenge into a tax-saving opportunity. Their approach not only provided for their healthcare needs but also resulted in significant tax savings—a win-win strategy for retirement planning.