We’ve all heard the sales pitches! “Permanent life insurance solves all of your problems!”
For those of you who have followed me for a period of time know I don’t believe this to be true. But at the same time, there is a large % of the financial advisor (and talking heads) population that blanketly tells people, “Don’t ever buy permanent life insurance.”
To me, this is a breach of fiduciary duty. Just because we all have our biases doesn’t mean we should PUSH those biases on someone’s personal financial situation. As my friend Cody Garrett likes to say, “Keep Finance Personal.”
1. 70% of Americans over 65 will need long-term care during their lives.
2. Fewer than half of you over the age of 65 own insurance to pay for long-term care. Essentially, you are planning to self-insure for long term care.
3. This is the crazy part. 70% of the care being provided is done by unpaid caregivers! Aka. family members…🤔
I wrote about long-term care planning before, but my convictions on this have only increased over the years.
In my previous article, I talked about considerations on whether or not you should purchase insurance.
We also just finished recording a three-part series on The Planning for Retirement Podcast (PFR) about how to fund long-term care costs. Episodes 22 and 23 were about using long-term care insurance and episode 24 was about how to self fund long-term care.
So why do these statistics bother me?
If the majority of retirees will need care, and they are intentionally not buying insurance, that means they plan to self fund for long term care(by default). However, why are family members providing the majority of long term care and not hired help!?
The answer: because there was no real plan to begin with. In reality, it was a decision that was never addressed, or perhaps in their mind they decided to “self fund.” However, that decision was never communicated to their loved ones.
Let me ask you. If you are in the majority that plans to self fund, what conversations have you had with your spouse? Your power(s) of attorney? Your trustee(s)? Do they know how much you’ve set aside if long term care was ever needed? Do they know which accounts they should “tap into” to pay for long-term care?
The chances are “no,” because I’ve never met a client who did this proactively on their own. Ever. And I’ve been doing this for 15 years.
So, this article is for you if you are planning to bypass the insurance route and use your own assets to “self fund long-term care.” I believe this is one of the most important decisions you can make when planning for retirement because it can save how you are remembered.
How much should I set aside to self insure long term care?
It is impossible to pinpoint the exact number YOU will need for care. But let’s pretend your long-term care need will fall within the range of averages.
On average, men need care 2.2 years and women 3.7 years.
The 2021 cost of care study by Genworth found that private room nursing homes cost $108,405/year. Assisted living facilities cost $54,000/year. These are national averages, and the cost of care varies drastically based on where you live.
So let’s use this ballpark figure of $118,800 – $238,491 for men, and $199,800 – $401,098 for women (2.2x the averages for men and 3.7x the averages for women).
The major flaw in using this math is that most people have some sort of guaranteed income flowing into their bank accounts.
Social Security Income
Pensions
Required Minimum Distributions
Of course, not all of that income could be repurposed, especially if you are married. However, perhaps 25%, 50% or 75% of that income could be repurposed for caregivers.
Let’s say you are bringing in $100k/year between Social Security, Pension, and Required Minimum Distributions. Let’s say you are married, and all of a sudden need long term care. For simplicity’s sake, your spouse needs $50k for the household expenses. The other $50k could be repositioned to pay for long-term care. After all, if you need care, you probably are not traveling any longer, or golfing 5 days/week. This unused cash flow can now be dedicated to hiring professional help and protecting your spouse from mental and physical exhaustion.
If we assume the high-end range for men of $238,491, but we assume that $110,000 could come from cash flow (2.2 years x $50k of income), then only $128,491 of your assets need to be earmarked to self fund long term care.
Hopefully, that’s a helpful framework and reassurance that trying to come up with the perfect number is virtually impossible. After all, you may never need care. Or, perhaps you will need care for 5+ years because of Alzheimer’s.
My key point in this article is to address this challenge early (before you turn 60), and communicate your plan to your loved ones.
What accounts are the best to self insure long term care?
My personal favorite is the Health Savings Account, or HSA. I wrote in detail about HSA’s in another blog post that you can read here.
Here’s a brief summary:
You can qualify to contribute to an HSA if you have a high-deductible health plan.
The contributions are “pre-tax.”
Earnings and growth are tax-free (you can invest the unused HSA funds like a 401k or other retirement plan).
Distributions can also be tax-free if they are used for “qualified healthcare costs.”
What is a qualified healthcare cost?
Look up IRS publication 502 here, which is updated annually.
One of the categories for qualified healthcare costs is in fact long-term care! This means you can essentially have a triple tax-advantaged account that can be used to self insure long-term care in retirement.
However, you need to build this account up before you retire and go on Medicare. Medicare is not a high-deductible health plan!
But, if you have 5+ years to open and fund an HSA, it can be a great bucket to use in your retirement years, particularly long-term care costs.
The 2023 contribution limits are $7,750 if you are on a family plan and $3,850 if you are on a single plan. There is also a $1k/year catch-up for those over 55.
So, if you’re 55, you could add up to $43,750 in contributions for the next 5 years. If you add growth/compounding interest on top of this, you are looking at 6 figures + by the time you need the funds for care in your 80s. Not bad, right?
Taxable brokerage accounts or "cash"
This bucket is another great option. Mostly because of the flexibility and the tax advantages of taking distributions. Unlike a 401k or IRA, these accounts have capital gains tax treatment. For most taxpayers that would be 15%, which could be lower than your ordinary income tax rate (it could also be as low as 0% and as high as 20%+).
If you are earmarking some of these dollars for care, I would highly recommend two things:
Separate the dollars you intend to spend for care and give this new account a name (“long-term care account”)
Invest the account assuming a time horizon for your 80s instead of your 60s. In essence, you can make this account more aggressive in order to keep pace with the inflation rate for long term care expenses.
What’s nice about this bucket is that it’s not a “use it or lose it.” Just because you segregated some assets to pay for care, doesn’t mean those dollars have to be used for care. When these dollars pass on to the next generation, they should receive a step up in cost basis for your beneficiaries. If the dollars are in fact needed for care, you will only pay taxes on the realized gains in the portfolio.
🤔 Remember when we talked about tax loss harvesting in episode 19? Well, this strategy could also apply to help reduce the tax impact if this account is used to self-insure long-term care.
Of course, cash is cash. No taxes are due when you withdraw money from a savings account or a CD. Now, I wouldn’t suggest using a CD or cash to self-insure care, simply because it’s very likely that account won’t keep pace with inflation. However, if there is some excess cash in the bank when you need care, this could be a good first line of defense before the more tax-advantaged accounts are tapped into.
Traditional 401ks and IRAs
This bucket is often the largest account on the balance sheet when you are 55+. However, many advisors and financial talking heads recommend against tapping these accounts to self insure long term care because of the tax burden.
Well of course, it may not be ideal as a first line of defense to pay for care, but if it’s your only option, “it is what it is.”
But here’s the thing. If you are needing long term care, you’re most likely over the age of 80. This means you are already taking Required Minimum Distributions or RMDs. If you have a $1mm IRA, your RMD would be $62,500 at age 85. Let’s say you also have Social Security paying you $24,000/year. That’s a total income of $86,500 that is coming into the household to pay the bills. This was my point earlier in that you likely have income coming in that can be repurposed from discretionary expenses to hiring some professional help for care.
This means that you may not need to increase portfolio withdrawals by a huge number if RMDs are already coming out automatically.
But yes, you’ll have taxes due on these accounts based on your ordinary income rates. And yes, if you increase withdrawals from this bucket, this could put you in a position where your tax brackets go up, or your Social Security income is taxed at a higher rate, or perhaps will have Medicare surcharges.
On the flip side, this could also trigger the ability to itemize your deductions due to increased healthcare costs. In fact, any healthcare costs (including long term care) that exceed 7.5% of your adjusted gross income could be counted as a tax deduction (as of 2023).
The net effect essentially could be quite negligible as those additional portfolio withdrawals could be offset with tax deductions, where applicable.
Life Insurance and Annuities
Maybe you bought a life insurance policy back in the day that you held onto. Or you purchased an annuity to provide a guaranteed return or guaranteed income. However, you may find that your goals and circumstances change throughout retirement. Perhaps your kids are making a heck of a lot more money than you ever did, so they don’t have a big need for an inheritance. Or, that annuity you purchased wasn’t really what you thought it was. You could look at these accounts as potential vehicles to self-insure for long term care.
Life Insurance could have two components – a living benefit (cash value) and a death benefit. In this case, you could use either or as the funding mechanism for long term care.
Let’s say you have $150k in cash value and a $500k death benefit. Instead of tapping into your retirement accounts or brokerage accounts, you could look at borrowing or surrendering your life insurance cash value to pay for care. Or, you could look at the death benefit as a way to “replenish” assets that were used to pay for care.
Annuities could be tapped into by turning the account into a life income, an income for a set period of time, or as a lump sum. All of those options could be considered when it comes to raising cash for this type of emergency.
Roth Accounts
This is the second most tax-efficient retirement vehicle behind the HSA. It’s not only a great retirement income tool, but it’s also a great tool to use for financial legacy given the tax-free nature from an estate planning perspective. However, this account could be used to self insure long term care without triggering tax consequences.
Let’s say you need another $30k for the year to pay for care. But an additional $30k withdrawal from your traditional 401k would bump you into the next tax bracket. Instead, you could look to tap into the Roth accounts in order to keep your tax bracket level.
Home equity
The largest asset for most people in the US is their home equity. However, people rarely think of this as a way to self insure long term care. In fact, this is why many caregivers are family members! They want their loved ones to stay at home instead of moving into a nursing home. But perhaps there isn’t a huge nest egg to pay for care. If you have home equity, you could tap into that asset via a reverse mortgage, a cash-out refinance, or a HELOC. There are pros and cons of each of these, but the reverse mortgage (or HECM) is a great tool if you are over the age of 62 and need access to your equity.
The payments come out tax-free, the loan doesn’t need to be repaid (unless the occupant moves, sells, or dies), and there are protections if the value of the home is underwater.
Inform your key decision makers
Now that you have a decent understanding of how much to set aside and which accounts might be viable for you, it’s time to have a family meeting.
If you’re married, have a conversation with your spouse.
If you have children, bring them into the discussion, especially those that will have a key decision-making role (powers of attorney, trustee etc).
You know your family dynamic best. The point you need to get across is that you do have a plan to self insure long term care despite not owning long term care insurance. Your loved ones need to know how much they could tap into (especially the spouse) in the event you need care. This is very important, give your spouse permission to spend! Being a caregiver, especially a senior woman, will very likely result in burnout, stress, physical deterioration, mental exhaustion, and resentment. If you simply leave it to your spouse to “figure out,” they will always resort to doing it themselves in fear of overspending on care.
❌ Don’t do this to them!
I hope you found this helpful! Make sure to subscribe to our newsletter below so you don’t miss any of our retirement planning content! Until next time, thanks for reading!
What factors go into retirement withdrawal strategies?
The primary concern for just about everyone I meet with is how to retire with the same lifestyle they currently enjoy. “Retiring” has a different meaning now than it did 20-30 years ago. Nowadays, people retire TO something. Whether it be to travel the world, spend time with family, volunteer, start a hobby, or work a dream job without compensation concerns. Naturally, income replacement is the primary topic for those that are approaching retirement. With pensions becoming less common, Social Security and income from investments have become the primary drivers to support the retirement lifestyle. My most recent article (link here) was about Social Security and how to maximize the benefits for retirement. Studies have shown Social Security represents approximately 40% of retiree’s income. Therefore, I get a lot of questions on how much clients should withdraw from their portfolios to subsidize the income gap.
It depends. There are two primary questions that we begin with to come up with the right answer. First, what are the main spending objectives in retirement?And second, what level of risk is acceptable? These factors work in tandem and create many hypothetical “right answers” depending on each unique client. This is why starting with a strategical financial plan with meaningful spending goals and meaningful stress tests is critical. All future financial planning decisions will be influenced by these goals, which I find evolve over time. As I continue to work with my clients, naturally new goals are added, and former goals are either accomplished or removed. What I find is that as folks are approaching retirement, we typically focus on the “needs.” Once they start to experience retirement and feel the plan is working, they can begin to relax and think more about their wish-list goals.
I want to clarify two housekeeping items first that are very important. First, there are a number of “what-if” scenarios that can impact anyone’s retirement. We could have a beautifully designed income plan that is completely wiped away from a significant healthcare or long-term care expense. I wrote about four of the stress-tests I run for my clients as they plan for retirement here. This article, however, will be focused solely on navigating a safe withdrawal rate, all else being equal. Second, I want to change the method of thinking from a safe withdrawal percentage to a safe withdrawal dollar figure. Using a safe withdrawal dollar figure ensures that the client’s spending goals can be achieved throughout their life (adjusted for inflation), regardless of short term swings in the market. I have found this method of withdrawals, known as a flexible withdrawal strategy, resonates with clients as they sleep better at night knowing they have a set income each month. In order to accomplish this, or any prudent income plan for that matter, we must have a defined distribution process to avoid a big mistake. I once met a client that had a dozen or so securities in his portfolio, and was selling his investments pro rata to meet his income needs. This is often a default method for big brokerage firms, but not a prudent distribution process. The reason being it will just about guarantee you are selling certain securities at the wrong time each distribution you make. Having a prudent distribution process is a critical assumption when we begin the stress tests, as a big mistake can completely negate years or even decades of growth. With that being said, I will reference withdrawal rates as an average percentage over the life expectancy of a plan, but understand they will fluctuate each year in practice.
Most people I meet with have one of the following primary income goals for retirement:
Replace income to maintain their current lifestyle, but without depleting the principal of their investments.
Replace income, but with the goal to maximize the legacy transfer to the next generations, or to charity.
Maximize spending and die penniless.
Replace income without depleting principal
I find most people strive for this in retirement, mainly because of the psychological benefits it provides. If you are burning through your principal in your early years, you might naturally have concerns about running out of money. I had a client I worked with years ago that was consistently needing about 8%-10% of the portfolio each year to supplement his Social Security. Each time we had market volatility, it was pretty much guaranteed I would get a call from him in a panic. Over the years, his portfolio was consistently declining in value. I kept reminding him that his burn rate was too high, but instead of looking at his own expenses, he blamed performance despite wanting to have a relatively safe portfolio. Conversely, my clients that are in a sweet spot for distributions don’t panic when we go through bouts of volatility. They are out enjoying retirement knowing we have a solid process and plan in place, which is my goal when I take on a new client.
In order to accomplish principal preservation while drawing income, we must first understand the objectives for income and the risk capacity for each individual. I started working with a client a few years ago that had a solid nest egg built up for retirement and wanted to see how to maintain her principal while replacing her pre-retirement income. However, she was in the mindset (like many folks approaching retirement) of making the portfolio ultra conservative before this transition period. After running some hypothetical scenarios, I showed her the results of our models. Looking at the illustration below, the results on the left show a moderate risk portfolio, which as you can see falls in the green zone, or the Confidence Zone. On the right, we modeled the impact of moving to a conservative risk. As you can see, becoming more conservative causes this plan to fall below the green zone, or Confidence Zone, which is not ideal. In some situations, clients that have saved more than enough for retirement can afford to reduce risk without jeopardizing the longevity of their plan. However, in other situations like the one below, one might need to maintain some risk in the portfolio in order to achieve their income goals and maintain principal over time. It’s critical to find that sweet spot of portfolio risk when implementing your distribution plan.
Why does reducing risk impact the probability of success negatively for this client? The reason is somewhat simple. Given the prolonged low interest rate environment we are still in, the more conservative investments are not yielding much in the way of annual returns. Therefore, the expected returns annually from a more conservative portfolio are going to be lower than a portfolio taking on a reasonable amount of risk. This resulted in a conversation of her wanting to maintain some risk in the portfolio so she didn’t have to worry about going through her nest egg too quickly. After all, she does have longevity in her family and we could be planning for a 30+ year retirement!
I have found that in general, if someone is more conservative, the average withdrawal rate needed to preserve principal will be in the range of 3%-4%/year. If a client is comfortable with some risk, 4%-5.5%/year can achieve the goal of income and principal preservation. Finally, someone who is comfortable with a significant amount of risk may even be able to get away with 6%/year or perhaps higher in average withdrawals. Inherently, the more risk one takes, the less probable the outcome is. I typically find folks that want to take on more risk will fall into the next category of replacing income but also maximizing legacy.
Replace Income but maximize legacy
For those who are looking to maximize legacy, of course we need to first make sure their income goals are taken care of. Once we have tested all possible outcomes and have a solid baseline average of withdrawals, we can then determine how this will impact their legacy objectives. Naturally, the lower the withdrawal rate the better. Sometimes, clients may only need 2%-3%/year from the portfolio. If they are generating an average of 5%/year in returns, this will allow them to grow their net worth over time and potentially keep pace with inflation. However, in other situations folks still need a reasonable amount of withdrawals to meet their spending goals. In any event, I will outline three strategies below to help with maximizing returns while drawing down retirement income.
Asset location strategy
Spending strategy
Tax efficiency
Asset Location is a buzz term used in our industry, but many clients I speak with don’t fully grasp what this means as they are more familiar with the term asset allocation. Asset allocation is the method in which you determine what percentage of your net worth is dedicated to a variety of asset classes to create the properly diversified investment strategy. Asset location is more specific on what asset classes you would own based on the different types of accounts you have. I’ll give you an example. I am working with a client who has one Traditional IRA (which is tax deferred) and another account that is a non-qualified brokerage account (which is taxable each year). We strategically own the tax efficient investments in the taxable account, and the tax inefficient investments in the IRA. This makes sense because the more tax efficient an investment is, the less in taxes you would pay on that particular investment. It’s like the old saying, “it’s not what you earn, it’s what you keep.” In this case, it’s not what her before tax rate of return is, it’s her after tax rate of return. Having an efficient asset location strategy can help with maximizing retirement income simply by taking a holistic view on what investments you should own in each type of account you have.
Having a spending strategy may feel like a given, but rarely do I hear people talk about this the right way. Many folks focus solely on what percentage of the account they can reasonably draw down. However, in order to maximize long term performance while drawing retirement income, you have to be strategic based on the timing of withdrawals. Let me explain. I have another couple I work with that has three buckets of accounts. One is a non-qualified brokerage account, the next are Traditional IRA’s, and finally they each have a ROTH IRA. Sequentially, most experts would agree that you should tap your brokerage account first, your IRA second and your ROTH IRA last. The reason is to maximize your after tax income as you’ve already paid taxes on the cost basis for that non-qualified brokerage account. Once you turn age 72, you will then be forced to make withdrawals on your Traditional IRA or 401ks. For your ROTH IRA, you won’t ever have mandatory withdrawals and they will be tax free if/when you do take money out (as long as they are considered qualified withdrawals). Therefore, we are taking the most risk in their ROTH IRAs, and the least amount of risk in their non-qualified brokerage account. By using this approach, we will experience less volatility on the account they are likely to withdrawal in the short term (brokerage account), and will be able to maximize the growth potential on the accounts they won’t be tapping into until longer term, if ever (ROTH IRA’s). I have found this approach works more effectively than incorporating a singular investment strategy across all accounts.
I talked a lot about tax efficiency in a previous article called the Tax Trap of Traditional 401ks and IRAs here. This goes hand and hand with a smart spending strategy. If you want to live a nice lifestyle but also maximize your legacy goals, consider what accounts are more or less tax efficient for that wealth transfer goal. With the new rules around the elimination of the stretch IRA, leaving your Traditional IRA or 401k to your children is not as tax friendly as it was before The SECURE Act was passed. Therefore, spend those during retirement and consider leaving the ROTH IRAs (if you have one) or even non-qualified brokerage accounts as your legacy assets. Currently, non-qualified accounts have the benefit of a step up in cost basis upon the owner’s passing, although this is currently in the cross hairs in Washington to potentially eliminate. However, under the current rules, a non-qualified account is a great tool to use for those wealth transfer goals. Therefore, you may want to try to preserve these assets more during retirement and increase spending on those traditional 401ks or IRAs. Another tool you could add to your arsenal, if you don’t have it already, is a permanent life insurance policy. This works beautifully with several clients I work with where legacy is an important objective. It allows for them to leverage the death benefit, which is passed on tax free, while only paying a relatively nominal premium while they are living. One theme I hear from these folks is there is a psychological benefit in knowing you have something that is guaranteed to pass along to the next generation regardless of what the stock market brings. It also gives them freedom to spend their retirement accounts without guilt knowing this legacy goal is taken care of by the insurance.
With all of this in mind, these strategies should apply to all three types of clients who are preparing for retirement. Those who want to spend income and preserve principal, those who want to generate retirement income and maximize inheritance, and those who want to spend it all while they are living. All prudent retirement plans should employ these three tactics. By not following a disciplined plan, the margin for error increases dramatically and the more prone the plan is to risk of failure.
Max spending with no inheritance
For the client who wants to maximize spending without leaving any inheritance, it can sometimes be unnervingas a financial advisor. However, we start with the same process of unpacking the goals and stress testing those goals based on the income sources and risk tolerance. The challenge is to figure out a scenario where the withdrawal rate in their last year of life is nearly 100%. Obviously, I say this tongue-in-cheek as that would involve knowing exactly how long the client will live. However, we will use our best guess based on longevity in their family history and our life expectancy calculators. Once we see how much cash can be raised from the portfolio, I will show the client the withdrawal rates over time, assuming an average expected return. Let’s take a look at this client below. She doesn’t have children and wants to spend it all while she’s alive. There are some charities she could leave it to, but she will probably give them money during her retirement years, especially when Required Minimum Distributions kick in. So, we went towards the path of max spending and dying without any assets left.
For this client, you can see the withdrawal rates start around 6%-10%/year the first 4 years. At age 70 she will begin taking Social Security and the withdrawal rate goes down a bit. However, looking into her late 80s and 90s, you can see how the withdrawal rates ramp up and at the last year of life expectancy, she is taking out nearly 100% of the portfolio balance. Obviously, you can see the reason this is unnerving. What if she lives longer than 94? What if there is a long-term care need or major healthcare expense? What if we have lower than expected average returns? What about inflation? All of these stress tests failed miserably in this type of scenario. Therefore, after sharing these results and discussing the potential risks, we backed down the rate of withdrawal slightly to create a buffer for those unexpected events. The good news is, I will continue to revisit this with her and track our progress as time goes on. If we run into some challenging conditions, we can have that discussion about trimming the withdrawal rate. Conversely, if we are going through periods of significant growth, we can potentially spend more or gift more in those years. I find this is a nice balance between maximizing spending, but also not doing something that will impact her ability to be financially independent. Nobody wants to be a burden on others!
In summary, withdrawal rates are not static in our world. We need to be dynamic to adjust to the cash needs of our clients. Additionally, the withdrawal rates will be driven by the primary goals of the client, the income sources available to achieve those goals, and the capacity for risk. This formula will bring to light what a reasonable amount of income that can be taken from the portfolio would be, adjusted for inflation over time. There is not one right answer, and it’s important to take all of your financial planning considerations, tax considerations and investment considerations before making any decisions.
My firm specializes in this type of planning and we are happy to help you prepare for retirement. You can schedule a no obligation initial consultation here, or by giving us a call at 904-323-2069.
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