Transitioning to retirement is exciting, but it also comes with its own challenges. After a lifetime of saving in retirement accounts, decades of deferred taxes start coming due as you pull money out. As retirees age and their financial and life circumstances change, many will seek out continuing care retirement communities (CCRC’s) for their golden years. At such a time, tax efficiency becomes a top priority consideration.
CRCCs can vary widely by cost and value. The range and quality of facilities and services will be reflected in the contract you sign. There are also monthly fees that are not fixed and could be adjusted periodically to cover additional operating costs. Some facilities will require a form of long-term care insurance, Medigap, or Medicare Part B, which can significantly increase the cost of living in a CCRC.
The financial condition of the community, which should be researched prior to signing a contract, can provide insight into its projected services, monthly fees, and the quality of healthcare you will encounter. Before signing a contract you might also want to speak with current residents about their experiences at the CCRC. And be sure to conduct a careful inspection of the facilities, taking notice of the apartments, cottages, dining room, and other facilities to determine if they suit you.
CCRCs offer multiple types of contracts. A common structure includes three levels of entry fees that address a wide spectrum of service, from full-life care to fees per service. The full-life care contract typically requires a higher entrance fee and offers lower and more predictable ongoing expenses. Fee-for-service contracts come with a lower pre-pay built into the entrance fee, which typically means greater ongoing expenses. The retiree must determine which contract fits their needs and wants. The type of contract will also determine the dollar amounts to be used in a CCRC-Roth conversion strategy.
CCRCs are often an attractive option for well-off retirees as they can provide a multitude of social benefits as well as a way to more consistently manage long-term healthcare expenses. When someone buys into such a community, they are essentially putting a down-payment on future medical expenses. Here is the kicker: Even if you are living independently at a CCRC, you are allowed to deduct a portion of the costs from taxable income as prepaid medical expenses. The strategy is appropriate for a retiree that has little to no taxable income and large medical expenses, such as is often encountered in retirees entering CCRCs.
Roth IRA conversion strategy
Roth IRA conversions are a common tax strategy for those who are not otherwise qualified to contribute to a Roth IRA due to income restrictions. The process involves rolling over qualified assets into a Roth IRA which creates taxable income for that year, which is what is needed to take advantage of the CCRC deductible medical costs.
The standalone benefits of a Roth conversion cannot be understated. A Roth account can provide a bucket of qualified assets offering tax-free growth as well as tax-free distributions when it is held for five years or longer. Nor do Roth accounts come with an annual required minimum distribution (RMD) as do traditional IRAs and other qualified accounts. RMDs can produce large tax bills on distributions that the individual might not have otherwise needed. A Roth account removes the requirement, allowing for tax-free growth with no RMD.
Breaking it down
By entering a CCRC, a retiree encounters a large initial fee as well as the monthly expenses of the community. A portion of these two expenses are classified as a prepaid medical expense, and thus can provide for a tax deduction. The percentage deemed “prepaid” is determined by the ratio of the CCRC’s aggregate medical expenditures in relation to their overall revenue generated by the resident fees, which means that living independently in the CCRC has no effect on the amount calculated for medical expenditures and the subsequent tax deductions.
Roth conversion creates two beneficial byproducts: initially, a steady after-tax savings bucket, and secondly, an annual income, which is necessary to benefit from the CCRC tax deductions. Once the amount of tax deductions are known, the retiree’s marginal tax bracket can be determined, and in many scenarios the tax deduction is large enough to reduce the retiree’s marginal tax bracket substantially.
The retiree’s monthly expenses can provide for ongoing annual tax deductions. It is not uncommon for the monthly expenses in a CCRC to be higher than a comparable apartment, and as much as 30 percent or more could be tax deductible. The difference in taxes between the original tax bracket and the new tax bracket is the amount that can be used for Roth conversions to fully maximize the tax deductions afforded by the CCRC expenses. The result is a growing Roth IRA account—steadily growing after-tax assets allow for more flexibility in the financial planning process—and most importantly, no usable tax deductions are left on the table.
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