Re-Thinking Retirement Accounts

December 30, 2019 Austin F DuBois

Millions of Americans have much of their savings in retirement accounts, such as a 401(k), IRA or 403(b). Many are aware of the income tax benefits of retirement accounts, but very few are aware of the possible pitfalls, specifically when it comes to long-term care. Long term care, along with the new SECURE Act provisions, make it necessary for people to re-think their retirement savings strategy.

Millions of Americans have much of their savings in retirement accounts, such as a 401(k), IRA or 403(b). Many are aware of the income tax benefits of retirement accounts, but very few are aware of the possible pitfalls, specifically when it comes to long term care. Long term care, along with the new Setting Every Community Up for Retirement Enhancement (“SECURE”) Act provisions, make it necessary for people to re-think their retirement savings strategy.

The original version of this article was written a few years ago, focusing solely on the long term care issues with retirement accounts, and concluding that a proactive strategy is the best way to protect retirement accounts. Over the past year, due to the impending SECURE Act, estate planning attorneys, financial advisors and CPAs are all starting to come to the same conclusion. So now more than ever, with multiple issues on the horizon, it is important to plan proactively.

Most people have a basic familiarity with the rules applicable to retirement accounts. During your working years, you can deposit pre-tax money in a retirement account and any growth from the invested assets is tax-deferred. These tax benefits, of course, come with strings attached. Other than a few minor exceptions, you cannot take any money out of the account prior to turning 59 ½, lest the IRS charge you a substantial penalty. When you do turn 59 ½, you can take money out of the account, but since you have not paid taxes on it yet, each distribution is treated as ordinary taxable income.

A second significant rule is that for traditional retirement accounts, you are required to begin taking distributions at least annually by April 1st after the year in which you turn 72 (this age limit was 70 ½ prior to Jan. 1, 2020). There is a minimum amount you are required to take out, called your Required Minimum Distribution (“RMD”). That amount is calculated based on the account owner’s life expectancy, as determined by the federal government. A significant financial penalty is imposed if the account owner fails to take out at least the RMD.

The primary benefit of retirement accounts is that they permit the accumulation of assets on a tax-deferred basis. People are typically instructed to wait as long as possible to take distributions out of the retirement account, and when distributions must be taken, to then take out only the minimum amount that the IRS requires. That way, the rest of the account can continue to grow tax deferred.

However, that single-faceted “strategy” considers only the income tax features of retirement accounts. Another factor to consider is the possibility that you might require long-term care. Since one of the best ways to save money in the face of long term care is to engage in Medicaid asset protection, it’s important to know the Medicaid rules surrounding retirement accounts. When long term care is in play, the existence of a retirement account can be a problem. For most assets, house, investments, savings, etc., we can set up a Medicaid Asset Protection Trust, fund some or most of the assets into that trust, and after a five-year period they will be protected if nursing home care is needed. We cannot put a retirement account into a trust–to do so would be to cash out the entire account, and pay regular income tax on the entire account–almost never a good idea.

The key is to plan proactively, because careful planning provides the best opportunity to avoid having to pay significant portions of retirement accounts for our long-term care.

There are a number of sources that claim that retirement accounts are “protected” against Medicaid, but that is dangerously inaccurate. The truth is this: the balance of a retirement account owned by a Medicaid applicant does not count against the applicant’s “resource allowance” for Medicaid eligibility purposes so long as it is in pay-out status. That is, as long as you are taking regular distributions from that account, in the amount that is required by the Medicaid agency, the balance will not count against you. But the Medicaid agency’s requirements are not known by most attorneys, CPAs, or financial advisors. This is an important caveat.

You can get Medicaid, which covers nursing home and other long term care costs, even if you have significant sums in retirement accounts. But that does not mean retirement accounts are protected in the Medicaid context. While you are otherwise financially eligible you will receive Medicaid coverage regardless of the value of your retirement accounts, any distributions that you take from the retirement accounts will almost certainly need to be paid to the nursing home or long term care provider. On top of that, it is not only the “required minimum distributions”, per the IRS’s rules. Instead, the local county Department of Social Services, or similar Medicaid agency, will require that you use a different government table (“Table S”, here) that requires you to withdraw more from your retirement account. Also, the amount must be withdrawn monthly, rather than annually. The result is that on a monthly basis, the retirement accounts are steadily depleted and paid to the nursing home. I would not call that “protected”.

The recent SECURE Act, signed into law by President Trump on December 20, 2019, changed another very significant feature of retirement accounts. Prior to the SECURE Act, when an account owner died, leaving the account to a non-spousal beneficiary, the beneficiary was required to begin taking required minimum distributions, but got to use his or her own life expectancy in calculating the RMDs. This typically was a big tax win, because the beneficiaries were usually children of the owner, and therefor significantly younger. Since they had longer life expectancies, they were required to take out a relatively small amount of money, allowing the rest of the account to grow tax-deferred. Not anymore! For retirement account owners dying after December 31, 2019, a non-spousal beneficiary will have to take out the entire account balance over the course of 10 years–and pay the much higher tax whilst doing so. Spousal beneficiaries are still able to roll over the account and treat it as their own–which only serves to delay the issue, not solve it.

For those of us in the industry, the trend should be clear: the government is realizing how great it’s been for retirement account owners over the past few decades, and they’re starting to put the squeeze on it, from multiple angles.

So what, then, is the solution? As usual, the best solution is to plan proactively with astute professional advisors. My recommendation is that, together with your accountant and financial advisor,
you analyze your current and future income needs and possible income tax liability. Then, instead of waiting until age 72, consider taking distributions from your retirement account before you are required to by the IRS, or in larger sums than the IRS requires. If the income tax liability is not so high, you can then shift that money into a truly protected form, such as a Medicaid Trust, a Long Term Care Insurance policy, or even simply in a savings or investment account, which provides better planning options. While no one (including me) likes the idea of paying more taxes that we have to, it is important to look at the situation holistically–it’s not just about the taxes you are paying now, but it is also about the money that may need to be spent on long term care costs, and the taxes that your beneficiaries may have to pay if a substantial part of their inheritance comes in the form of an inherited retirement account. Developing a proactive strategy allows the account owner to take control of how that account is managed and distributed, and then how the remaining assets are managed and protected, and with a good plan, preserved for the person or family.