Health care generally represents one of the most significant expenses you may encounter after leaving the workforce. The average retiree today can expect to pay about $5,000 a year on health care premiums and out-of-pocket expenses, for a grand total of some $275,000 per couple.1 Depending on the region and the level of medical care you are accustomed to, the numbers could be quite a bit higher. And then there’s long-term care. The median cost of a private room in a nursing home is nearly $100,000 annually, but can cost more than $150,000 in some states.2
A few factors add to the seriousness of the challenge. One is that people are living longer. The current life expectancy for men is 76 and for women it’s 81. More to the point, if you live to 65, on average you’ll make it to 84 (men) or 87 (women). Living into your 90s is much more common than it once was. On the bright side, this is a tribute to healthy lifestyles and medical advances, but it comes at a time when health care inflation has been outstripping general inflation by about 70% annually. And in spite of widespread conventional wisdom that “60 is the new 50” (and, I assume, “70 is the new 60,” and so on) the average age of retirement has fallen to 62—even though Medicare doesn’t kick in until you reach age 65.
Clearly, health care costs can have a pernicious effect on a retirement nest egg—potentially cutting into available income for other needs or reducing the assets available for heirs. Moreover, people have a tendency to underestimate how much health care will cost (see display). As such, it’s important to consider health care outlays within the broad context of your financial plan, and to be familiar with the building blocks that can make that planning more successful. Here are a few data points and ideas to remember.
Health Care Curveball
In a survey, many retirees were particularly surprised by the extent of their health care expenses.
Actual Cost vs. Expectations
Source: Employee Benefit Research Institute and Greenwald & Associates, 2017 Retirement Confidence Survey.
Medicare: Knowing Your ABCs and Ds
Medicare is a key foundation of retirement medical coverage in the U.S. Anyone with a 10-year work history (or a spouse who has worked that long) is eligible for Medicare starting at age 65.3 Medicare Part A “hospital” coverage includes stays at inpatient hospitals and skilled nursing facilities, hospice, lab tests, surgery and home health care. Part B is optional coverage for medical expenses such as doctors’ visits and other outpatient care, preventive services, ambulance and medical equipment. It does require a premium, currently ranging from around $105 to $300 per month, depending on your level of income. Part D is prescription drug coverage and also requires a premium.
When you sign up for Medicare, your projected income can affect your costs. If you’re already enrolled in Social Security, you are automatically enrolled in Medicare. If you are not, you have a seven-month window starting three months before the month you turn 65 to enroll. Delaying beyond this point can trigger penalties and increase the cost of Part B coverage permanently. If you’re still employed at age 65, a special enrollment period will apply when you leave the workforce.
Prior to retirement, most people don’t know that Medicare Parts A, B and D only pay for about 80% of covered expenses, so it’s common to obtain so-called “Medigap” policies (or Medicare Supplement Plans), which are private plans designed to cover openings in Medicare coverage (deductibles, copays, out-of-pocket expenses, etc.). As an alternative, you may choose a Medicare Advantage Plan (Medicare Part C), which provides all-in-one managed care under Parts A, B and D. Some find the latter choice to be limiting, as you have to stay in network when you see doctors.
Within Part D, there’s an additional gap in prescription drug coverage known as the “donut hole.” After a $405 deductible, Medicare covers expenses up to $3,750, but the individual must pick up the cost from that level to $5,000. Discounts are available for brand-name as well as generic drugs to help offset the impact of the donut hole.
The combination of public and private insurance will tend to cover the bulk of needs, but how you finance premiums is a topic in itself. Several tax-advantaged approaches are available.
Health Savings Accounts
These accounts are available only for individuals who have “high-deductible” insurance plans at work—currently those with a deductible of $2,700 and maximum out-of-pocket cost of $13,300 for a family. (Amounts for singles are half as much.) These accounts provide a triple tax advantage that is unique among savings vehicles. Annual contributions of up to $6,850 (for families) are (1) made on a pre-tax basis, (2) allowed to grow in the account without current taxation and (3) ultimately can be withdrawn tax-free if applied to medical expenses. If you don’t turn out to need the proceeds for qualified purposes, you pay ordinary income tax on the withdrawals as you would with an IRA, assuming you have reached age 65. (Below that age there is an additional 20% penalty on such withdrawals.)
Often those who “retire” actually wind up opening small businesses. If so, it may make sense to establish a high-deductible plan to capitalize on HSA advantages.
Retirement Accounts, and Other Funding Options
Your IRA can be another good source of tax-advantaged savings for health care. Assuming you are age 59½ or older and have left funds in a Roth IRA for at least five years, you can withdraw them for any purpose, including health care. If you withdraw funds from a traditional IRA for medical expenses and itemize your personal income taxes, then you can write off the health care costs above 7.5% of adjusted gross income4 to offset the income from the qualified account. It may also be advantageous to pull money out of a cash-value life insurance for medical payments. As long as you only withdraw to the extent of your basis (or contributions) to the policy, you won’t incur any income tax or penalty. Finally, home equity may sometimes be appropriate to draw from to pay for health care costs. Note that recent curbs on deductions of home equity interest could affect this choice.
Health Care Savings Options: A Comparison
|Savings Vehicle||Health Savings Account||Traditional IRA / 401(k)||Roth IRA/401(k)|
|Treatment of Contributions||Tax Deferred5||Tax Deferred||Taxable|
|Contribution Limits||$3,450 (Single)||$5,500 / $18,5006||$5,500 / $18,5006|
|Regular Distributions||Tax-free if qualified||Ordinary income||Tax-free if qualified|
|Early Distributions||No tax or penalty if qualified||Limited; penalties may apply7||Limited; penalities may apply7|
|Penalty for Early / Nonqualified Distribution8||20%||10%||10%|
|Required Minimum Distributions||None||Age 70 1/2||Age 70 1/2 for retirement plans only9|
|Beneficiary Tax Treatment||Subject to Ordinary Income Tax||Tax Deferred (With RMD)||Tax-free (With RMD)|
The Long-Term Care Challenge
Many people worry about the often-daunting costs of care late in life. Although Medicare covers up to 100 days in a hospital or skilled nursing facility, it does not cover custodial care that may be needed as you lose the ability to handle daily living skills such as eating, bathing or dressing. Sometimes care is provided by a family member, but the mental and physical burden can be substantial, not to mention their potential loss of income from taking on those duties.
To protect yourself (and them), you may wish to buy insurance that covers such care, whether in a nursing facility or at home. At one time, the primary choice might have been a traditional long-term care policy, but those policies have increased in price and some insurers have dropped them altogether. An alternate (and less expensive) solution today is a hybrid life policy with a long-term care rider.
Such policies are not for everyone. A useful rule of thumb is that anyone with up to $1 million in assets at purchase (typically age 50 – 60) should probably not get long-term care insurance, as living expenses will likely leave them in a position at some point to access state Medicaid benefits for care. Those with north of $5 million in assets, in contrast, can arguably self-fund (although you have to ask yourself whether you want to set aside the needed assets when the time comes rather than outsourcing the risk to insurers). The range where long-term care insurance is in play is typically between $1 million and $5 million in assets, and in that case you should take a hard look at the numbers to make a decision that’s right for your personal situation.
The Medical Expense Deduction
With the increase in the standard deduction increasing to $24,000 (for joint filers in the 2018 tax year) and new curbs on mortgage interest, and state and local tax deductions, far fewer people will choose to itemize their deductions going forward. However, one deduction that could tip the scale toward itemization is the medical deduction. Medical expenses are deductible beyond 7.5% of adjusted gross income for 2017 and 2018, and 10% in 2019. This includes after-tax contributions to insurance, as well as doctors’ visits, hospital stays and long-term care expenses, among many other outlays. Particularly in the case of self-insured long-term care, the deduction can make a huge difference to a family’s ability to handle medical costs in addition to more typical living expenses.
In planning for retirement, there are many issues to consider: lifestyle, location, interests and whether you want to leave a legacy to heirs. Health care is another factor that, depending on individual circumstances, could have a major impact on your resources. Keep in mind that health care costs tend to increase as you move through retirement, just as travel and other diversions become less prominent.
The nature of your potential expenses, including health care, is something to consider when assessing your investment objectives and portfolio mix. Those who are younger and want to build up an asset base for health care and other costs may wish to have a more aggressive array of assets, weighted toward stocks. Once you are nearing or starting retirement, a shift toward bonds and other more income- and capital preservation-oriented assets often makes sense, though arguably only to a point: Depending on your circumstance you may want to maintain exposure to assets with capital appreciation potential to help outpace inflation and cover costs over an extended period.