Unwelcome Long Term Care Expenses Could Be a Gold Mine of Income Tax Deductions
Estate, Trust, & Wealth Preservation Alert 10/26/16 John T. Bannen
The Likely Need for Some Long Term Care Services.
Long term care expenses for persons with cognitive impairments such as Alzheimer’s disease have been described as “help you don’t want at a cost you cannot afford.” Nonetheless, our parents—or even we ourselves—someday may need such help. While the cost of such services may be covered by long term care insurance—either a freestanding policy or one combined with life insurance—due to the high cost of the coverage many people may choose to self-insure part of the long term care risk, or even all of it, if assets are sufficient.
Long Term Care Expenses Can Be Income Tax Deductible.
What many people do not realize is that the entire cost of such long term care, whether received in an assisted living or a skilled care facility or in your home, may be deductible as a medical expense assuming that the person needing care meets certain requirements (discussed below) and that the expenses (together with any other medical expenses) exceed 10 percent of the person’s adjusted gross income. Expenses covered by insurance cannot be deducted.
Thus, while the out-of-pocket payment of uninsured long term care expense may involve a substantial cash outlay, under the right circumstances the payment of these expense may qualify for as much as a 50 percent (depending on your combined state and federal tax bracket) subsidy from the government in the form of income tax savings on other income which essentially becomes tax-free because of the deduction.
Payment of Long Term Care Expenses May Reduce One’s Taxable Estate at Death and So Reduce Estate Taxes.
Note as well that the net after-tax cost of the care will also reduce any federal estate tax you may owe. Thus, if you would be subject to the estate tax you would receive an additional 40 percent discount on the long term care expenses that you pay. To be subject to the federal estate tax, your estate must exceed $5,450,000 or $10,900,000 for a married individual. Both exemption levels are adjusted annually for inflation. While few people are subject to the federal estate tax (only about 2/10th of 1 percent) many more people (approximately 50 percent) are subject to the income tax. Thus, while estate savings for the payment of these expenses will be rare, income tax savings, though not necessarily at the maximum rate, will be more common.
How Then Does One Qualify for a Medical Expense Income Tax Deduction for Unreimbursed Long Term Care Expenses?
To be eligible for the medical expense deduction the person receiving the long term care must be chronically ill. A person is chronically ill if they meet one of two tests:
First Test: Activities of Daily Living Test
The inability to perform two out of six activities of daily living without substantial assistance will qualify long term care expenses for medical expense deduction. The activities are:
- Transferring out of bed
Note: If the person can do all of these, but needs substantial assistance (e.g., physical presence) to do them properly or safely, then the person qualifies for the income tax deduction.
Second Test: Cognitive Impairment Test
If the person has a severe cognitive impairment (e.g., Alzheimer's disease or other dementia) and requires substantial supervision to protect himself or herself from threats of his or her safety, then the person qualifies for the income tax deduction.
Certification by Licensed Health Care Professional
The foregoing conditions need to be certified by a licensed health care practitioner and the services must be provided under a care plan.
Cautious taxpayers will want to have as part of their tax records a letter from a physician determining that the person receiving the care cannot perform the activities of daily living or suffers from the required cognitive impairment. The letter should also indicate that the long term care services are medically required and should be provided either in the patient’s home, an assisted living facility or a skilled care facility. If the care will be provided in the patient’s home, the care plan will likely be prepared based on a needs analysis prepared by a registered nurse or a social worker and will be staffed by a social service agency. In addition to a physician, a licensed social worker from the agency providing the care could also provide the required letter. See Appendix A and B for sample letters.
Accelerating Taxable Income
It is not unusual for a person’s deducible long term care expenses to exceed the taxable income of a person receiving the care. If so, then the deductible expenses unable to be used are wasted. Unlike charitable contributions, there is no five-year carryover for unused medical expense deduction. In such cases, accelerating or creating taxable income may be advisable even if the cash is not needed. The most common way to accelerate taxable income is to take additional distributions from traditional IRA accounts (the ones that create taxable income—not Roth IRAs where distributions are not taxable). Distributions may also be taken from non-IRA annuities where income has been building up for years. Even if you don’t need the extra cash to pay long term care expenses because other sources of cash exist, taking the distributions and cleansing the funds of the income tax taint could be quite beneficial. Your heirs then receive tax-free dollars instead of ones which would be reduced by income taxes. Note, accelerating income will cause the 10 percent disallowance amount to rise, so the increase in income must be balanced with the unused deduction.
Nervous About Long Term Care Expenses?
There are four basic ways to approach long term care expenses:
- Hope to die in your sleep at age 95 when the first signs of Alzheimer’s disease appear. (Hard to guarantee because the timing is tricky.)
- Fully insure your risk by buying a freestanding long term care policy or a life insurance policy with a long term care rider. (Hold on to your checkbook, because unless you are quite young, the premiums can be heart-stopping).
- Give everything away five years before you and your spouse need care and have the government take care of you. (This is not what made America great, and you will not be at the “Four Seasons” of skilled care facilities.)
- Some combination of self-insurance and long term care insurance. This is what I have most typically seen and often advised unless the clients can pay their long term care expenses out of their customary stream of income (nice if you can do it).
Your IRA Might Be Your Long Term Care Policy
If you have been prudent enough to have produced a large retirement plan accumulation, either in an IRA or a qualified pension or profit-sharing plan, and if your retirement needs are more than cared for by other assets, you might see your retirement plan as a kind of long term care policy.Again, assuming you don’t need all of these benefits for retirement, they could come out nearly income tax-free as the long term care expenses which they pay are largely income tax deductible.A freestanding long term care policy might provide $5,000 per month for a six-year period, or a benefit pool of $360,000. If you have an extra $360,000 to spare in your IRA, you have your long term care policy. Note, if you had purchased a long term care policy that pays for this care you would still have the $360,000 (net of income taxes). But if your concern is simply tax favored cash flow, your excess IRA money may be the ticket.
While long term care expenses are not something clients aspire to, even if they have a long term care policy to pay for the expenses, our future medical care is an area where all too often we are not driving the bus. Nonetheless, if the worst happens, there may be some consolation that the cost for the care you need but did not want is largely income tax deductible.
For questions, contact John T. Bannen at [email protected]/(414) 277-5859, or your local Quarles & Brady attorney.
Sample Physician’s Letter
To Whom It May Concern:
RE:[Name of Patient Receiving Care]
I am a physician duly licensed to practice medicine and am one of the treating physicians of [Name of Patient].In the course of my treatment I have determined:
[Activities of Daily Living]
[Name of Patient] is unable to perform without substantial assistance at least two of the six activities of daily living, namely eating, toileting, transferring in and out of bed, bathing, dressing and continence, for a period of at least 90 days due to a loss of functional capacity.For this reason I have determined that the patient should receive long term care services,
[Name of Patient] is disabled due to severe cognitive impairment which requires substantial supervision to protect him/her from threats to his/her safety and for this reason have determined that [Name of Patient] should receive long term care services,
[Skilled Care Facility]
at a skilled care facility providing such services.
at home pursuant to a comprehensive needs-based analysis completed by a licensed health care professional such as a registered nurse or a licensed social worker.
[Signature of Physician]
Professional Registered Nurse or Licensed Social Worker
To Whom It May Concern:
RE:[Name of Patient Receiving Care]
I am a professional registered nurse/licensed social worker and have examined [Name of Patient], have reviewed his/her needs and have determined that:
[Activities of Daily Living]
He/She is unable to perform without substantial assistance at least two of the six activities of daily living, namely eating, toileting, transferring in and out of bed, bathing, dressing and continence and that this condition has or will continue for a period of at least 90 days due to a loss of functional capacity.
He/She is disabled due to severe cognitive impairment which requires substantial supervision to protect him/her from threats to his/her safety and for this reason have determined that [Name of Patient] should receive long term care services.
For this purpose, I have developed the attached homecare plan to meet his/her needs.
[Attach Care Plan Developed by Nurse/Social Worker]
Signature (Nurse or Social Worker)