The latest tax news from Washington State includes a long- term care tax on W2 income. For details, please refer to our Financial Plan, Inc. blog post authored by our own Justin Gross, CFP® entitled What to Know and How to Plan for Washington State’s LTSS Trust Act.
While the aforementioned article lays out the facts regarding the new law, this article presents my professional opinion and concepts for consideration, particularly for successful wage earners.
Opinion: Long term care insurance is rarely the most effective solution
The reason for the existence of insurance is distribution of risk. Insurance can be an effective solution to the extent that the event to be insured has two characteristics:
- The event is catastrophic.
- The event is rare.
The premature death of a 30-year-old breadwinner is an event that meets both of those characteristics: It can be catastrophic to a surviving spouse and children (as it results in a complete loss of all future income) and it is quite rare, affecting only about 1 in 700 households each year. As a result, the risk of catastrophic loss can be vastly reduced by insurance; replaced by a very cost-effective term life premium.
If an event is not catastrophic, it is typically wiser to simply live with the risk and pay for the loss whenever the event occurs. There are many such events that do not cause catastrophic loss, from dental bills to the breakdown of an appliance or body damage on a car. Over time, the person who has insurance coverage for these events is very likely to pay more than those who choose to self-insure. By choosing insurance coverage, they are effectively paying for the less-than-catastrophic events through the conduit of the insurer AND paying the administrative costs and profits of the insurance company.
If an event is not rare, there are not enough insureds over which to adequately spread the risk. Long term care scenarios are not rare. The actual probability of an individual needing either in-home extended care or care in a facility at some point in their life is well above 50%, according to the most recent numbers on LongTermCare.gov. The rough estimate is that the risk is spread among only two or three insureds, resulting in very high premiums. The very frequent claims add to administrative costs, which cause yet higher premiums and lower benefits.
Fortunately, for successful investors, there is another solution. Consider that the costliest form of long-term care takes place in an assisted living or nursing facility.* When a single person is moved to a facility, a sale of their former residence will free up the home equity to pay the costs. Likewise, if a married couple moves to a “continuing care community”, the former residence can be sold. The equity in the residence often exceeds the maximum benefit available from modern long- term care policies. In addition to the residence, successful investors have significant financial assets that will often be sufficient to pay the costs of long-term care without an eventual complete depletion of assets.
Those who might be better candidates for long-term care insurance are those without sufficient assets to self-insure. Unfortunately, they are the very people who are most negatively impacted by large premiums. High long- term care premiums can increase the withdrawal rate on a retirement portfolio, contributing to an eventual complete depletion of capital, even if a long-term care scenario never occurs.
In my opinion, long-term care insurance is rarely the most effective solution to the risk of a long-term care scenario. Unless the investor is extremely risk-averse it is best avoided in favor of other solutions.
*In-home care is often part-time, and the hourly rate for these services is in the range of $20 per hour. At that rate, 20 hours of these services per week amounts to just over $20,000 annually. In contrast, nursing home care is far more costly. According to SeniorLiving.com, the average cost of nursing home care in Washington State in 2020 was $131,400 per year.
Opinion: Washington State’s plan is damaging to high wage earners
The maximum benefit through the Washington Plan is $36,500. The new payroll tax will be charged at a rate of .58% on all W2 income including hourly wages, salaries, bonuses, and company stock, (such as RSUs). To qualify for the benefit, a wage-earner must pay for at least 10 years, or 3 of the past 6 years. The total tax paid by wage earners over various time periods who earn $100,000 or more is listed below. The wages are assumed to grow at an inflation rate of 3% per year.
Numbers in bold indicate tax higher than maximum possible state benefit.
|W2 Income||Tax over 1 year||Tax over 10 years||Tax over 25 years||Tax over 40 years|
This is every bit as bad as it looks. Even without the probable real tax increases, the wage earner making $250,000 will pay $52,866 over 25 years for the unlikely possibility of a $36,500 benefit. The $1 million wage earner over a 25- year career will pay $211,464 in tax for a maximum benefit of $36,500!
It gets worse: On the margin, people who do not have health problems will be more likely to obtain private coverage, exempting themselves from the plan. This leaves a disproportionate number of people who have difficulty obtaining long-term care coverage on the plan. This “selection risk” will almost certainly cause very large, real increases in the tax, which are not included above.
In summary, the plan is abysmal in proportion to wage levels. For high wage earners it is nothing short of theft. To further illustrate the damage, consider these points:
- A wage earner who will retire within three years has no chance of any benefit but is not exempt from the plan.
- If a wage earner moves or retires out of state, benefits are forfeited.
- The state plan will not pay until 2025 and will not pay unless a certain number of years of tax payments have been made.
Every wage earner has a choice: either pay the tax or opt out by buying a private plan. A cost comparison is in order:
Consideration: Cost Comparisons for One Scenario
The rule does not specify a minimum amount of long- term care benefit necessary to opt out. Therefore, my advice would be to obtain the minimum amount that an insurer will write. As of this writing, the minimum coverage that has been proposed to us is $3,000 per month over a two- year period for a total of $72,000, or roughly double the state plan benefit of $36,500.
Here I will analyze one scenario that I ran on an example client: male, age 60, standard health rating, earning $500,000 in W2 income per year with 3% raises, who will be retiring in 10 years. I begin with this assumption:
The wage-earner is self-insured, so any long-term care benefit, whether through the state or a private plan, holds little value. Therefore, the primary goal is to reduce costs.
There are three options that I will compare:
- Traditional long-term care insurance
- Hybrid Life/Long Term Care Insurance with a return of premium (ROR) rider
- Washington State Plan
Traditional long-term care coverage: Traditional Long-Term care policies are straightforward: In return for a monthly or annual premium, a benefit is paid when long-term care is required.
A male, age 60 with a standard health rating can obtain a traditional long-term care policy paying $3,000 per month over a 2- year benefit period, considered worthless under our assumptions. The premium is $1,192 per year, or $11,920 in total premiums over ten years, at which time the policy would be cancelled. If we discount each annual premium at a 3% inflation rate, the present value cost is $10,473.
10-pay Hybrid Insurance with ROR: With a life insurance/long-term care insurance hybrid, the policy provides both a small death benefit and an “accelerated care” benefit which can qualify for a long-term care benefit, both considered nearly worthless under our assumptions. The insured pays a much higher annual premium for ten years, at which time the policy is “paid up” and endows. After year ten, the policy can be surrendered, and the total premiums paid are returned. This feature is pertinent, as our goal here is to reduce costs by surrendering the policy at retirement, not to maintain a lifetime, long-term care benefit.
A 60-year-old male, rated standard, can obtain a Hybrid Policy with a $3,000 per month long-term care benefit paid over a 2-year time period for a premium of $8,502 per year, or $85,020 in total premiums over ten years, at which time the policy would be surrendered, and the full $85,020 would be recovered. The premiums, when discounted at a 3% inflation rate, have a present value cost of $74,700. The $85,020 when discounted at a 3% inflation rate, has a present value of $63,263. Therefore, the present value cost is the difference: $11,468.
The Washington State Plan insures for a $3,000 benefit for one year, considered to be nearly worthless under our assumptions. If we assume a $500,000 W2 income with 3% raises, the total tax over ten years is $33,241. When discounted at a 3% inflation rate, the present value cost is $28,150.
For this scenario, the summary comparison is:
|Plan||Present Value Cost|
|Traditional Long Term Care Insurance||$10,473|
|Hybrid Life/Long Term Care with ROR||$11,468|
|Washington State Plan||$28,150|
Under our assumptions above, the state plan costs nearly triple the private plans. Private insurance; either the traditional or hybrid plan, should be obtained if possible. The difference in present value cost between the traditional and hybrid plan is too small to be decisive. Other factors are more important when deciding between the two. For example:
Factors that may indicate a traditional lifetime pay long term care policy is a wise choice:
- Would the high hybrid premiums replace investment contributions to a portfolio of equities, business opportunities, or other high-priority personal goals? If so, the hybrid plan has a higher opportunity cost, and the traditional plan may be more appropriate.
- Is there some concern that the State plan will implode and be cancelled? In that case, the traditional plan will be favorable over a hybrid plan because the premiums for the traditional plan could be discontinued, whereas if the premiums for the hybrid plan don’t continue for the full 10 years, the return of premium is lost. This would make the hybrid plan far more costly.
Factors that may indicate a “return of premium” hybrid plan is a wise choice:
- Will the high premiums for the hybrid plan replace current over-spending? If so, the hybrid plan is a useful “forced savings”, making it somewhat more attractive.
- Long Term Care Insurers have been known to increase premiums, even when the policy design calls for level premiums. A hybrid plan is less vulnerable to premium increases because once the policy is “paid up”, no future increases can take place.
- Is the insured under the age of 40? It may be difficult to obtain traditional coverage, leaving a hybrid life/long-term care plan as the only option.
The numbers and the recommendations will change depending upon the age and wage level of the insured, the discount rate used, and the number of years expected until retirement. It is highly advised to retain the services of a CFP® practitioner to run the present value cost numbers for each individual, and if private insurance is obtainable and favorable, implement through an insurance agent who will not oversell long-term care insurance.
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