Can Health Savings Accounts Be a Bulwark Against Long-Term Care Costs?

Morningstar reports:

“Many retirement accumulators take pains to dot the i’s and cross the t’s of their retirement plans. They noodle over their portfolios’ asset allocations, carefully calibrate when they’ll begin claiming Social Security benefits, and think hard about withdrawal rates.

But many such painstaking retirement planners don’t give another major variable more than the periodic anxious thought: how to pay for long-term care. And is it any wonder so many people are in denial? For one thing, it’s a flip of the coin as to whether you’ll need long-term care: 52% of people turning 65 are expected to have a long-term care need during their lifetimes, and another 48% will not. The prospect of needing long-term care is inherently unpleasant, and that care can also be ruinously expensive, running upward of $100,000 per year in urban areas.

Long-term care insurance should, in theory, neatly protect against that risk, but horror stories abound. Premiums have skyrocketed on many policyholders over the past few decades, and many people who have wanted the insurance have been denied due to health considerations. I’ve also heard anecdotes about people with long-term care insurance having difficulty getting their claims reimbursed, though, in the interest of fair disclosure, I’ve also heard from people with long-term care insurance who said the claims process was no trouble at all. Hybrid life/long-term care insurance and annuity/long-term care insurance policies are coming on strong as an alternative to pure long-term care insurance, but they’re not without drawbacks, as discussed here.

Given all of that, is it any wonder so many people have decided to either a) hope for the best that they’ll never incur long-term care costs or b) self-fund long-term care expenses using their investment assets or the sale of their primary residence?

But there’s an underdiscussed way to defray long-term care costs, and that’s by bringing a health savings account into the action. These accounts, which come with prodigious tax benefits, can also be used to pay long-term-care premiums, assuming the policy qualifies. Alternatively, HSA assets can be used to cover long-term care costs incurred later in life. But as useful as HSAs can be in this context, the old adage that HSAs are best suited to the “healthy and the wealthy” is apt: For people covered by high-deductible healthcare plans with health issues who don’t have a large stash of liquid assets to cover out-of-pocket health expenses, using HSA funds to defray long-term care costs isn’t a realistic strategy.

What’s so Great About HSAs?
Before we delve into the viability of an HSA for long-term care funding, let’s review health savings accounts generally: who can use them and for what, as well as what the tax benefits are.

Health savings accounts are designed to help people pay for healthcare expenses that aren’t covered by their insurance. Not just anyone can contribute to an HSA: You have to be covered by a high-deductible healthcare plan. In 2018, for a plan to qualify as a hig-deductible healthcare plan, the plan must have a minimum deductible of $1,350 (singles) or $2,700 for a family plan. Additionally, only people who are not covered by Medicare can contribute to an HSA. For 2018, the HSA contribution limit is $3,450 for individuals and $6,900 for families. (Those limits increase to $4,450 (singles) and $7,900 (families) for savers older than 55.)

Of course, most of us would rather not be saddled with a bunch of out-of-pocket healthcare costs, and that’s the trade-off of being covered by a high-deductible healthcare plan. But premiums on the plan are usually significantly lower than is the case with conventional insurance coverage such as PPOs; that savings should, at least in theory, enable the insured party to set more money aside in the HSA. Additionally, some employers make HSA contributions on behalf of their employees.

But the really big advantage of using an HSA is that the tax benefits associated with this wrapper are unparalleled in the whole tax code. Specifically, you can contribute pretax dollars to the HSA, the money grows tax-free as long as the assets stay inside the account, and withdrawals for qualified healthcare expenses are also tax-free. Once you reach age 65, you can still tap your HSA assets tax-free for qualified healthcare outlays, but at 65 you can also withdraw them without penalty for any other expenses. You’ll owe taxes on those non-healthcare withdrawals after 65, but in that case the HSA is receiving the same tax treatment as a tax-sheltered account like an IRA or 401(k).

HSAs are still pretty new, and most people still use them as they were originally designed: to defray out-of-pocket healthcare expenses on an ongoing basis. But HSAs’ tax benefits are magnified for people who invest the money in long-term assets and hold them for many years. As discussed here, a buy-and-hold HSA investor would beat an investor in a taxable account walking away, and would even earn a higher aftertax return than an investor in a 401(k).

Here are two instances of how an HSA can be used to help cover long-term care.

Case 1: Use HSA Assets to Pay Long-Term Care Insurance Premiums
For HSA investors who would like to purchase long-term care insurance, HSA assets can be used to pay the premiums. That can make purchasing long-term care insurance more psychologically palatable than using non-HSA assets to pay the premiums, especially if your HSA dollars are getting taken out of your paycheck each month and you never “see” the money.

But there are a couple of caveats. First, the long-term care insurance must be a “qualified” long-term care insurance contract; most policies on the market today are tax-qualified, but check with your insurance provider to be sure.

Second, the amount of HSA assets that can be withdrawn each year to cover long-term care insurance depends on your age: In 2018, people between 41 and 50 can withdraw $780 of their HSA assets to cover long-term care premiums; people between 51 and 60 can steer double that amount ($1,560) to cover long-term care premiums; those between 61 and 70 can withdraw $4,160; and those 71 and older can withdraw $5,200. (Long-term care premiums typically scale up with age, so it makes sense that the allowable withdrawals would increase, too.) Those limits typically increase a bit each year.

The third (and to mind the biggest) caveat associated with using an HSA to cover long-term care premiums is that by pulling from the HSA on an ongoing basis, an individual loses some of that tax-free growth potential that comes along with letting the HSA assets ride up until or into retirement. It’s also worth noting that long-term care premiums paid out of non-HSA funds can be deducted, but thanks to the new tax laws, many fewer taxpayers are likely to benefit from such itemized deductions than in the past. To take maximum advantage of the tax-free compounding that comes along with an HSA, an investor would steer the maximum amount to the HSA each year, invest the money in long-term assets, and use other assets to cover health-care expenses (including long-term care insurance premiums) on an ongoing basis.

Case 2: Use HSA for Out-of-Pocket Healthcare Costs
The second way that HSA assets could be used to cover long-term care expenses would be to pull the money out of the account when such costs are actually incurred, likely later in life.

In contrast with the first use case, the big plus is that this strategy best harnesses the tax-free growth potential that comes along with the HSAs. Qualified HSA withdrawals–and most long-term care costs would qualify–would be tax-free; withdrawals post-age 65 for other expenses would be subject to ordinary income tax but no penalty, as outlined above.

The big caveat, of course, is whether it’s possible to achieve critical mass to cover long-term care costs via an HSA. And that depends on a couple of things–when the saver gets started and how much the account earns over the holding period.

If a 40-year-old stashes the maximum allowable amount per year (at today’s max of $3,450) for 25 years, leaves the money undisturbed, and invests in long-term assets that return 5%, he or she would build up about $165,000 by age 65. While additional contributions wouldn’t be available once the saver is Medicare-eligible, the money could continue to grow in the account. Assuming a 5% return, he or she would have amassed nearly $437,000 by age 85.

On the other hand, the person who waits until age 55 to begin contributing the max each year (in this case $4,450) to an HSA for long-term care costs and earns a 5% return would have $56,000 once he or she is Medicare-eligible, 10 years later. Assuming that money continues to grow inside the HSA and earns 5% for another 20 years, it would amount to about $149,000.

Neither are sums to sneeze at, of course, but it’s also worth keeping the rate of long-term care inflation in mind–4.5%, according to Genworth’s latest data run. At that rate, even a one-year stay in a nursing home–roughly $100,000 in today’s dollars–would cost more than $725,000 (!) in 45 years. In other words, people who are using an HSA to be a bulwark against significant long-term care expenses should consider lining up additional funds elsewhere; the HSA might not be enough. Investors contemplating this strategy should also bear in mind the particulars of inherited HSA assets, as discussed here.

Yet even though HSA assets may not be sufficient to cover long-term care costs in total, the accounts can be an effective–and tax-efficient–component of a long-term care action plan.