Using your IRA or 401(k) for Long-Term Care: A Case Study

Last week here on the blog we talked about the value of long-term care insurance, and specifically how hybrid long-term care insurance can be the “best of both worlds” to give you guarantees for both life insurance and long-term care insurance in the same policy. This week we wanted to talk about how money in your 401(k) or IRA is a good place to look for funds for that type of coverage. One couple we are working with right now is a good case study of how to move a chunk of pre-tax money from one place to another to optimize what you get for your (hard-earned and carefully saved) dollars.

401(k) to Fund LTC
401(k) to Fund LTC

A case study of how one couple is using part of their 401(k) to fund a variety of future needs.

The Scenario

James and Diane have been married for many years. Looking down the road at their golden years, they noticed a few challenges were likely to come up, and they came to us to help make sure they were prepared. James is age 63 and is still working but hopes to retire soon. Diane is 65 and retired. Together they have a son with special needs, and it is important to them that he is taken care of after they are gone.

While James and Diane are fairly well-off, the majority of their money is in James’ 401(k). They have over $2 million in that account and only another $15,000 in a checking account. They plan to leave everything to their son but need to minimize the taxes owed on those assets before they are transferred. Their son is currently receiving government benefits, and a big, lump sum, pre-tax payout may cause complications or interruptions in those benefits.

Diane’s mother passed recently, after receiving 11-12 years of various levels of long-term care. Like a lot of daughters her age, Diane spent a lot of time and energy with her mother over the course of these years, managing her mother’s household affairs, facilitating care arrangements, and assisting with care wherever she could. Diane and James know that it’s possible they could need care too, but their son would not be in a position to help like Diane did for her mother. This means not having long-term care coverage would be a double-whammy: they would need to spend more money for their own care, and it would be a dollar-for-dollar reduction in the amount they could leave for their son.

In this situation, hybrid long-term care is a great option. Since they have so much pre-tax money in the 401(k), moving some of that into insurance helps solve several problems at once. It will provide for care for James and Diane that their son is unable to provide, and it will also protect any money not used for care as a tax-free life insurance benefit.

(Sidenote: They plan to use a special-needs trust to provide for their son’s financial needs, but a trust cannot be a beneficiary of a 401(k) or IRA, so we are working with them on moving the rest of the money into the trust over time, minimizing the taxes using other solutions not covered on the blog today.)

Listen to learn more about what factors went into choosing this product for this couple:

The Solution Breakdown

A long-term care policy will have a maximum amount that is paid per month, as well as a maximum paid out overall. If you use less money than the maximum per month, you will be eligible to receive payments for a greater number of months until the lifetime benefit is reached. For a policy covering a couple, this lifetime benefit is for all coverage needs of both people combined, not per person.

It was important to purchase a policy with a large benefit amount because this would be the main source of funds for any care needs. (Again, since this is a hybrid policy, any money not used for care will not be wasted but will instead be transferred to the beneficiary as life insurance.) We settled on a coverage amount in Year 1 of $6,000/month and a maximum benefit of $399,896. We also added an inflation rider, so the coverage amounts go up over time. By the time James and Diane are in their 80s, the monthly benefit will be $10,518, and the maximum benefit will be $701,226.

To pay for this coverage, James will make a one-time, in-service rollover payment of $256,667 from his 401(k) into an IRA annuity. After that, all the coverage and benefit amounts are guaranteed, and they do not need to pay any taxes on the large amount moved all at once.

Internally, the insurance company will continue to make transfers from the IRA annuity into the policy to fund the coverage. Every year for 10 years, the insurance company will move $30,800. This way the money can continue to grow to cover 10 years of inflation and a slightly higher benefit than if the insurance was funded all at once. It also protects James and Diane from a tax bomb of realizing the full amount as income in one year. Instead, they will owe taxes on each of these smaller, annual transfers. Paying the taxes on the transfers makes all benefits received tax-free, regardless of when they are paid out.

If James and Diane make it to the end of their lives with needing any of the long-term care benefits, their son will receive a life insurance check for $199,948, deposited into the trust.

If you don’t have $2 million dollars, that doesn’t mean you are disqualified from this type of coverage or planning. These policies are available at a range of coverage amounts; for a single person we usually recommend at least $100,000 of premium, and for a couple something closer to $150,000. Either way, we would love to talk to you about how these policies work or other creative ways to fund your long-term care needs, legacy plans, and charitable goals.

Have questions? Contact us today.