Long-Term Care Insurance (LTCI): Shrewd Move or Big Ripoff?

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[This is a guest post by David Graham, MD.  He and I commiserated by email about starting our blog’s last year.  His site is FIPhysician.  As the name implies he reached FI and enjoys helping other physicians get there too.  He coaxed me into taking a CFP course online at BU. He has been writing more and is on my list of physician bloggers. If you like this, read his other guest posts at my site, XrayVSN, The Physician Philosopher, EarlyRetirementNow, White Coat Investor,DrBreatheEasyFinance, DebtFreeDr, and Physician on FIRE.-WD]

Wealthy Doc wrote a great piece asking “Is Long-Term Care Insurance a Waste of Money?”

He suggests you build wealth and self-insure.

In the comments section, I proposed those with a net worth above $3M should self-insure. The White Coat Investor thought the number is closer to $1.5M.

It is fun to read the rest of the comments—the hate from the insurance industry is on display in spades.

Morningstar recently put the self-insure number above $2.5M. The title of this piece, however, is “There no magic number for self-funding long-term care insurance.” Instead, they suggest you:

1. Gage the likelihood of needing long term care
2. Ballpark the cost of care (with this document)
3. Customize based upon your situation and preferences
4. Think through the back-up plan
5. See if you can afford it
6. Segregate assets set aside for long term care from other assets

For those who don’t want to self-insure and are considering Long Term Care Insurance (LTCI), should you consider traditional LTCI or a hybrid product? 

In order to answer that question, let’s review what is available and think a little about the tax implications of each.

Tax Considerations for Traditional LTCI

Let’s start with traditional LTC policies. These policies underwrite morbidity risk. They are less common now than in years prior because of the increase in horror stories. Traditional policies may be expensive given chronically low-interest rates, longer life spans, and increasing medical costs. Premiums are subject to increase over time.

When shopping for LTCI, watch out for “non-qualified” policies. Not many of these are sold anymore, but reimbursement of expenses may be included as ordinary income from non-qualified policies.

Premiums paid to traditional LTCI are tax-deductible for individual taxpayers. There is, of course, a 10% floor in 2019 that must be met to itemize these as deductions. The 10% floor is difficult to get above given the large current standard deduction. 

The amount of the premium that is deductible depends on your age. That is, someone in their 70’s can deduct $5270 a year, whereas someone in their 40’s can only deduct $420.

Some states have tax deductions as well. Partnership Plans are important to consider if you think you may eventually qualify for Medicaid.

A business owner can often deduct the full amount, but this is a complex topic and depends on the type of business entity. See Kitces for general reference on business deductions.

What about the tax treatment of reimbursements? 

As with health insurance, you can exclude payments for personal injury or illness from LTCI. There is a limit, about $370 a day in qualified expenses. Payments above this are fully taxable unless actually used for long term care.

Paying LTCI Premiums from a Health Savings Account

Usually, only medical expenses (rather than insurance expenses) qualify for reimbursement from health savings accounts (HSAs). LTCI premium payments, however, are in fact HSA eligible.  

The same age-based limits above apply. Any amount above the limits requires after-tax payment. Obviously, if you use the HSA to fund premium payments, you can’t turn around and deduct the payments as this would be double-dipping.

Hybrid LTCI Policies

Let’s move on to Hybrid LTC/Life Insurance policies.

More salesmen are pushing hybrid policies, where you get permanent life insurance with a long-term care rider. 

The riders vary. Many allow access to the cash value or death benefit if needed for LTC expenses. For example, you could get 2% of the death benefit a month in advance to pay for long term care.

For (often) a lump-sum premium payment, your heirs can get a death benefit. In addition, these policies have a small amount of cash value and a defined dollar amount of LTC benefits.

Obviously, you can use one of these three benefits. So, if you use the LTC rider or access the cash value, the death benefit either shrinks or goes away entirely.

Hybrid policies are relatively expensive and in reality, don’t do anything well. The death benefit is small and may decrease with age. The cash value is low for the cost.

As for paying long term care costs, traditional LTCI policies are more effective and pay more. An advantage: premium is paid up in advance so not subject to increases.

Folks like these policies, however, because if they don’t “use” the LTC benefit (say they die in their sleep), they still get something for their money (the death benefit). All is not “lost.” Or, they can use the cash value instead, if needed.

This is a similar argument for Variable or Equity Indexed Annuities rather than single premium immediate annuities (SPIAs).

With the expensive fancy annuities, you still get “something” if you die early. Of course, there are massive downsides to these annuities compared to straightforward, traditional annuities like SPIAs. Hybrid policies are like an expensive swiss army knife when all you may need is a good old-fashioned steak knife for your dinner.

Tax Implications of a Hybrid Policy

Hybrid policies have significant tax shortcomings. They are not tax-efficient; this is a downside most folks don’t think about. The salesmen won’t necessarily say anything about the inefficiencies: “consult with your tax advisor” is what you are likely to hear.  

Premiums are never deductible.

As for reimbursement of expenses, hybrid policies payout basis (the after-tax money you paid for the policy) first, leaving the fully taxable excess behind.

Neither of these is a good feature. No deduction going in, and your after-tax money coming out first.

So, in general, traditional LTC policies are more effective and more tax-efficient than hybrid policies.

But we haven’t yet even discussed the most problematic feature of hybrid policies.

Should You Use your Hybrid Policy or an IRA to Pay for Long Term Care?

Think about this for a second: if you have an IRA and a hybrid policy, which would you rather use for long term care expenses? 

You would rather use your IRA. Really? But you bought the hybrid policy just in case you needed long term care.

So, you have long-term care insurance, but you shouldn’t use it?

Exactly.

If your goal is to leave money to your heirs, use the Always Taxable money in the IRA to fund health care costs. Then, if healthcare-related spending is above the 10% AGI floor—as is common in years where you have massive LTC bills—you might get a tax deduction.

When you spend from the hybrid policy, there is no possibility of a tax deduction.

In addition, spending down your IRA on health care means less fully taxable income for your heirs. Thus, you save the tax-free death benefit in the hybrid life insurance policy.

Your heirs would rather receive a tax-free death benefit from the hybrid policy than pre-tax income from the IRA.

So, hybrid policies are less effective, not tax-efficient and even if you have one (and an IRA), you shouldn’t use it.

When might a hybrid policy be a good idea?

Using 1035 Exchanges

In general, if you have old annuities or permanent life insurance, consider a 1035 exchange if you decide you want LTCI.  [Wow.  I thought I was sophisticated because I’m familiar with 1031 Exchanges.  I’ve never even heard of 1035 -WD]

The advantage here: take tax-deferred growth in these products and use them for another purpose without paying the taxes.

This is especially true for an annuity which is otherwise fully taxable as a death benefit.

Or, if you have tax-deferred growth in a life insurance policy, use this money tax-free to pay qualified LTCI claims after a 1035 exchange to an appropriate hybrid policy.

Again, Kitces has a great review on the topic.

Yes, 1035 exchanges are complicated. They can make sense if you have an old annuity or life insurance policy not otherwise of use. 

Especially consider a 1035 exchange if there is a lot of tax-deferred growth and you have a high probability of needing long-term care.

The long and the short: leverage an old product into something you might have a better use for.

Annuities with LTC Riders?

Yup. There are “hybrid annuities” as well.

Usually, these are Fixed or Equity Indexed Annuities with income riders used for LTC expenses. Often, with fees and expenses, returns are zero or negative. 

However, they build up 2-3x the initial investment (in a fictional separate account) for LTC expenses.  Of course, your premium is utilized initially and the fictional money only tapped if there are still LTC needs after your money is gone.

In reality, only consider an LTC annuity if you are in poor health. Annuities with income riders require minimal underwriting to purchase.

If you die before you use the rider, you heirs get the value of the annuity. Of course, the death benefits of annuities are fully taxable.

If you die while taking income, heirs usually get the initial premium minus any paid income.

LTCI Conclusion

In retirement income planning, the decision about long term care insurance is tough. Single folks and those without legacy or charitable goals are less likely to want it.

If you don’t have much, consider a partnership plan or plan to spend down for Medicaid.

If you have “enough” to self-fund or self-insure, likely more than $2.5M, the decision is more based on your individual health and personal risk preferences.

In the un-sweet spot in the middle, the choice is most difficult.

If you have an annuity or permanent life insurance policy you don’t need, a 1035 exchange to a hybrid policy is something to think about.

But if you can afford one, a traditional LTCI policy is better. [Oh, the insurance salespeople will be so confused by all this.  Are we the good people or the evil enemy? -WD]

When shopping for a policy, a great resource is the Long-Term Care Insurance Policy Checklist by the Wall Street Journal. 

Wealthy Doc suggests that Long-term care insurance is a waste of money. Yup. It is. [Hmmm, is that what I said?  I didn’t mean it always is a waste.  I think it makes sense for some people.  I listed some of the benefits. I’m just trying to get buyers to understand what they are buying. -WD]

Celebrate when you waste money on term life or auto insurance and don’t use it. If you have long-term care insurance and don’t use it, great!

Sometimes, especially with insurance, wasting money is good.

Hungry for more details? Read an example of paying Long-Term Care expenses out of an IRA in this post.

About the Author

David Graham, MD is a practicing Infectious Disease physician and blogs at FiPhysician.com. After discovering his passion for personal finance, he started a Registered Investment Advisory to promote his mission “Financial Literacy for Physicians.” For personal enjoyment, he recently sat for and passed the CFP exam.

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