The Hidden Risk of Self-Funding Long-Term Care Costs

The Hidden Cost of Self-Funding Long-Term Care

There’s no question that some clients have the balance sheets to pay for long-term care out of pocket if the need arises. On the surface, self-funding can feel like a straightforward and logical decision.

But this is often one of those situations where just because you can does not mean you should.

Why Clients Choose to Self-Fund

In practice, the choice to self-fund is frequently driven, at least in part, by avoidance. Clients may not want to dwell on the possibility of needing care later in life.

As a result, the conversation often centers only on how to pay for care, rather than how to plan for the risk itself. When that happens, an important part of the equation can get overlooked.

The Tax Impact Is Often Missed

From a pure funding perspective, transferring the risk to an insurance company almost always comes at a significant discount.

What is commonly missing from the self-funding analysis, however, is the tax impact. Unless the client is paying directly from a non-interest-bearing checking account, every asset liquidation used to cover care expenses can create a taxable event.

Whether those assets are taxed at capital gains rates or ordinary income rates, the taxes can add up quickly and materially increase the real cost of care.

Qualified Plan Assets Can Create a Bigger Tax Burden

For many Americans, the majority of their net worth is concentrated in qualified plan assets.

Distributions from these accounts used to pay for care are fully taxable at ordinary income rates, both federally and, where applicable, at the state level.

Annuities Can Present Similar Challenges

Annuity assets can create a similar issue.

Clients often mentally earmark annuities as their “care bucket,” but the last-in, first-out tax treatment means withdrawals are 100% taxable as ordinary income until all gains have been depleted.

Higher Income Can Increase the Overall Cost

Increased income from these distributions may also push the client into a higher tax bracket.

When that happens, the cost of self-funding becomes even more pronounced.

Can Care Costs Be Deducted?

Some clients may assume these taxes can be offset by deducting the cost of care. That may be true in certain cases, but not universally.

Two factors can complicate this strategy.

Not All Expenses Are Deductible

Only the actual cost of care qualifies.

In assisted living situations, for example, rent is often excluded, even though it may represent a significant portion of the total cost.

In contrast, if full-time memory care is required, all costs, including rent, may be deductible.

The 7.5% AGI Threshold Matters

Even when expenses are fully deductible, the 7.5% of adjusted gross income threshold must be met before any deduction applies.

This also assumes the client is itemizing deductions. While that is often true for high-net-worth households, clients with more modest assets and simpler financial lives may find that the standard deduction is high enough that itemizing provides little or no benefit.

The Real Takeaway

Self-funding only makes sense if the true cost of that approach is lower than an insured solution.

Making that determination requires accounting for every contributing factor, not just the visible dollars going out the door, but also the tax consequences and opportunity costs.

Planning Can Help Under Either Approach

The good news is that there are ways to mitigate taxes under either approach.

On the insurance side, tools like the Pension Protection Act and case designs that utilize extended premium payment schedules can help minimize or even eliminate taxes at the time of purchase.

For clients who do self-fund, strategies such as loss harvesting and thoughtful asset selection can help reduce the net tax impact.

The Key Question for Clients

At its core, the conversation comes down to a simple question for clients who intend to self-fund:

Which assets will you actually use to pay for care, and have you fully considered the tax ramifications of that decision?

More often than not, exploring that question in depth leads to a different conclusion than the client initially expected. It can also open the door to an insurance-based solution that may be more efficient than it first appears.

Let’s Talk

If this sparked questions about a current client or an upcoming case, let’s talk.

We work alongside advisors to evaluate funding strategies, tax implications, and insured alternatives so you can make recommendations with confidence.