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, even logical decision. But this is often one of those situations where just because you can doesn’t mean you should.
In practice, the choice to self-fund is frequently driven—at least in part—by avoidance. Clients don’t want to dwell on the possibility of needing care later in life. As a result, the conversation tends to center solely on how to pay, rather than planning for the risk itself. When that happens, an important part of the equation gets overlooked.From a pure funding perspective, transferring the risk to an insurance company almost always comes at a significant discount. What’s 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 creates a taxable event. Whether taxed at capital gains or ordinary income rates, those taxes can add up quickly and materially increase the real cost of care.
Several common scenarios can exacerbate this issue.
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.
Annuity assets present a similar challenge. 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.
Layer on top of that the possibility that increased income from these distributions pushes the client into a higher tax bracket, and the cost of self-funding becomes even more pronounced.
Some may assume that these taxes can be offset by deducting the cost of care. That may be true in certain cases—but not universally. Two factors complicate this strategy.
First, 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 represents a significant portion of the total cost. In contrast, if full-time memory care is required, all costs—including rent—may be deductible.
Second, 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’s 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.
So what’s the 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.
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 reduce the net tax impact.
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—and opens the door to an insurance-based solution that may be more efficient than it first appears.