When families are facing long-term-care expenses, failure to adapt their investment strategies and tax planning to accommodate those costs could have a devastating effect on family wealth and the ability to fund needed care.
Thomas West, a senior associate with Signature Estate & Investment Advisors, leads a team of financial professionals whose mission is to secure and protect wealth for families facing uncertainty due to disability, illness or death.
He and his colleague Joseph Dawkins, an associate adviser at SEIA, attempted to quantify the financial impact of poor financial stewardship during an LTC crisis. The results of their initial research are fascinating.
They deliberately started with a $2 million portfolio, a level that Mr. West said “would give most retirees a reasonable sense of security about their ability to withstand the impacts of the cost of care.”
MODEL PORTFOLIOMr. West and Mr. Dawkins then created a profile of a married couple whose $2 million portfolio was evenly divided between a traditional tax-deferred individual retirement account and a nonqualified investment account. They assumed an annual income of $142,000, including a $40,000 pension, $30,000 in Social Security benefits, $52,000 in required minimum distributions from the IRA and $20,000 in interest.
They also assumed $210,000 in annual expenses, meaning that the couple would have to dip into savings to maintain the healthy spouse's living expenses of $60,000 per year and pay for $150,000 in LTC costs, increasing at a 6% annual inflation rate.
Then they ran three examples to review the potential financial risks to the portfolio, including a sequence-of-return risk for a stock portfolio, interest rate risk for a laddered Treasury bond portfolio and IRA taxable-distribution risk.
They found that the usual sequence-of-return risk was exacerbated by the ever-increasing LTC costs.
Assuming that all $2 million was invested in the S&P 500, Mr. West and Mr. Dawkins back-tested two scenarios: five years of care beginning Jan. 1, 2003, during a bull market, and five years of care beginning Jan. 1, 2008, during one of the most severe market routs in history.
The ending value of the 2003 sequence was $2,230,872. The ending value of the 2008 sequence was $1,053,245.
The difference between drawing down assets beginning in a bull market and a bear market was nearly $1.2 million, enough to fund 7.85 years of long-term care.
Next, they modeled investing all $2 million in a laddered intermediate Treasury bond portfolio in a rising-interest-rate environment and compared the results with stashing all $2 million in a fixed-interest certificate-of-deposit account paying 2% per year. They assumed that the Treasury portfolio would mirror the 1954 rate rise, when 10-year Treasuries increased 144 basis points over five years, not unlike the gradual movement in rates over the past year.
The results were even more dramatic.
The Treasury portfolio was nearly wiped out after five years when LTC costs were growing at a rate of 6% per year. Meanwhile, the $2 million CD portfolio had an ending value of nearly $1.3 million.
Choosing the Treasury bond investment strategy over the fixed-interest CD would have cost the client 8.58 years of care.
TAX-FREE DISTRIBUTIONSFinally, Mr. West and Mr. Dawkins looked at the impact of taking only the required minimum distributions from the $1 million IRA that was invested in CDs earning 2% per year, compared with taking additional distributions from the IRA to take advantage of the maximum Schedule A tax deduction for LTC expenses. In effect, all the IRA distributions would be tax-free due to the large deduction for LTC costs.
Funds used for five years of care would total $877,000 under both scenarios, but the tax-efficient strategy of taking an additional $306,513 out of the IRA over five years to pay for care would preserve about $101,000 in assets, assuming a 28% federal income tax rate and a 5% state income tax rate. That additional $101,000 would pay for nearly seven additional years of care.
“Every year that you didn't take advantage of additional tax-free IRA distributions, it cost the client about one month worth of the cost of care,” Mr. West said.
EXPANDING THE SCOPEThe next challenge is to figure out what to do with this information.
Mr. West said he'd like to work with academic researchers to expand the scope of his thesis, testing the results for a diversified portfolio using Monte Carlo simulations to account for a variety of investment results.
In the meantime, he has developed some rules of thumb for financial advisers working with clients who are facing large medical or LTC expenses topping $100,000 per year.
First, Mr. West recommends taking IRA required minimum distributions at the beginning of the year and depositing the money into the cash reserves of the nonqualified investment account — then paying for all the care out of that account.
Mr. West also recommends suspending any tax withholding on Social Security or pension benefits, as it is likely that the client's large medical expense deduction will wipe out any income tax liability.
Toward the end of the year, estimate the potential Schedule A tax deduction for the cost of care. Subtract the required minimum distribution from the tax-deductible amount and withdraw any additional funds from the IRA to take full advantage of the deduction.
For 2014, taxpayers 65 and older can deduct medical and long-term-care expenses in excess of 7.5% of their adjusted gross income. Taxpayers under 65 can deduct expenses in excess of 10% of their AGI.