The Tax Time Bomb of Self-Funding Long-Term Care Costs

Many individuals have the financial capacity to self-fund long-term care (LTC) expenses. However, just because someone has the assets to cover these costs does not necessarily mean that self-funding is the most efficient or strategic approach. Many opt for self-funding without fully considering the tax consequences and financial trade-offs, often due to reluctance to confront the reality of potential care needs. This mindset can lead to significant financial inefficiencies and lost opportunities for wealth preservation and tax optimization. 

The Hidden Costs of Self-Funding Long-Term Care 

When evaluating LTC funding strategies, it’s essential to consider the substantial tax implications associated with liquidating assets to cover care expenses. Unlike insurance, which transfers the risk to an insurer and provides leveraged benefits, self-funding long-term care often results in unnecessary tax burdens. Unless paying directly from cash reserves held in a non-interest-bearing checking account, asset liquidation can create taxable events that may erode wealth more rapidly than anticipated. 

Key Tax Considerations for Self-Funding 

Several factors exacerbate the tax burden for those choosing to self-fund their care: 

Taxation of Qualified Retirement Accounts 

A significant portion of wealth is held in tax-deferred qualified retirement accounts such as IRAs and 401(k)s. Withdrawals from these accounts to pay for care are subject to ordinary income tax rates at both the federal and state levels. Large withdrawals could also push individuals into higher tax brackets, increasing their overall tax liability. 

Annuity Tax Treatment 

Many annuities earmarked for future long-term care (LTC) costs are subject to last-in, first-out (LIFO) tax treatment, meaning that initial withdrawals consist entirely of taxable gains until all earnings have been depleted. This results in a 100% taxable event at ordinary income rates, further compounding the tax burden. 

Capital Gains Exposure 

Individuals holding appreciated non-qualified investments may need to liquidate assets to cover care expenses, which can trigger capital gains taxes. If the sale of these assets significantly increases taxable income, individuals could face Net Investment Income Tax (NIIT) and phaseouts of deductions or credits. 

Potential Tax Deductions: A Limited Offset 

While some argue that LTC costs are deductible, this benefit is often overstated due to two primary limitations: 

Not All Costs Are Deductible 

The IRS allows deductions only for qualified medical expenses, which may exclude a significant portion of assisted living costs, such as rent. Full-time memory care or skilled nursing facility costs are generally deductible, provided the individual meets the IRS qualifications. 

The 7.5% AGI Threshold 

Medical expenses, including LTC costs, must exceed 7.5% of adjusted gross income (AGI) before any deductions apply. Individuals must itemize deductions, which is less common given the high standard deduction. 

Comparing Self-Funding vs. Insurance Solutions 

When evaluating whether self-funding long-term care is a prudent strategy, a holistic cost-benefit analysis that includes taxation, liquidity, and opportunity costs is necessary. In many cases, an insured solution provides a superior financial outcome due to the tax efficiency and leverage of insurance products. 

Tax-Efficient Insurance Solutions 

Leveraging the Pension Protection Act 

The Pension Protection Act​ allows individuals to exchange non-qualified annuities for tax-free LTC benefits under a 1035 exchange. This strategy can eliminate the LIFO tax burden and create a more efficient funding source. 

Hybrid LTC Policies

These products offer a combination of life insurance or annuities with LTC benefits, providing tax-free distributions for care expenses. Premiums can be structured to minimize tax exposure by using extended payment durations or funding through irrevocable trusts. 

Using Health Savings Accounts (HSAs) 

Individuals with HSAs can utilize tax-free distributions to cover qualified long-term care (LTC) expenses, thereby further reducing their taxable income. 

Key Question: Have You Considered the Tax Impact? 

A critical consideration for those considering self-funding long-term care: Which assets will you use, and have you considered the tax ramifications of this strategy? The answer often reveals that the real cost of self-funding is significantly higher than initially perceived. 

By incorporating tax-aware planning and leveraging insurance solutions, individuals can adopt a more efficient, tax-advantaged LTC funding strategy. This approach helps preserve wealth while ensuring access to necessary care without unnecessary tax exposure.

Not sure which strategy best fits your client’s needs? The LIFE Brokerage team is here to help. Our experts specialize in designing tax-efficient insurance solutions tailored to your needs. Contact us today to explore smarter alternatives to self-funding long-term care.