Retirement planning involves many decisions, from determining withdrawal strategies to balancing tax efficiency and estate goals. Among these considerations is whether to keep funds in a traditional IRA or convert to a Roth IRA. While much attention focuses on tax implications and income needs, one critical factor often overlooked is how traditional IRAs can serve as a strategic tool for covering medical expenses, particularly long-term care (LTC).
Here, we explore how traditional IRAs can act as a built-in safety net for healthcare costs and compare their effectiveness to a Roth conversion strategy.
Traditional IRA: A Long-Term Care Safety Net
Traditional IRAs allow for tax-deferred growth, meaning contributions are often deductible, and taxes are paid on withdrawals in retirement. For retirees facing significant medical or LTC expenses, this tax structure offers unique advantages:
- Tax-Free Medical Withdrawals
The IRS permits deductions for unreimbursed medical expenses exceeding 7.5% of adjusted gross income (AGI). While traditional IRA withdrawals are taxable, the deduction can offset this burden. For example:
- A retiree with high medical costs may reduce their taxable income after deductions, effectively lowering or eliminating taxes on IRA distributions.
- Timing Benefits for Medical Expenses
Medical expenses often increase later in life, particularly for LTC. Traditional IRAs can serve as a financial reservoir for these costs, enabling retirees to leverage tax advantages during lower tax-bracket years.
- Preserving Liquid Assets
By tapping a traditional IRA for healthcare expenses, retirees preserve other assets for discretionary spending or legacy planning.
Roth IRA: Flexibility Without Tax Offset
Roth IRAs, funded with after-tax dollars, offer tax-free growth and withdrawals, making them attractive for many retirees. However, their utility for covering medical costs is less pronounced compared to traditional IRAs:
- No Tax Offset for Medical Expenses
Unlike traditional IRA withdrawals, Roth distributions don’t qualify for medical expense deductions. This means retirees with significant healthcare costs miss out on a tax advantage available with traditional IRAs.
- Upfront Conversion Costs
Converting to a Roth IRA involves paying taxes upfront, potentially reducing the account’s overall value. For retirees early in retirement or with high income, the conversion cost may outweigh the long-term benefits.
- Prioritizing Estate Planning Over LTC Needs
While Roth IRAs are excellent for leaving tax-free inheritances, traditional IRAs may better align with personal needs if healthcare or LTC expenses are the priority.
Key Considerations for Your Retirement Plan
When deciding between a traditional IRA and a Roth conversion, consider:
- Tax Brackets Now and in the Future
- If you anticipate being in a lower tax bracket later in life, a traditional IRA may maximize your tax efficiency, especially when combined with medical deductions.
- Projected Healthcare Costs
- For retirees expecting significant LTC needs, the built-in flexibility of a traditional IRA can outweigh the predictability of a Roth IRA.
- Estate Planning Goals
- If leaving a tax-free legacy is a priority, Roth IRAs are advantageous. However, for those focusing on personal healthcare, traditional IRAs provide a direct solution.
- Conversion Timing and Costs
- Assess whether the upfront tax hit of a Roth conversion is justified, especially if future medical expenses could reduce taxable income through deductions.
Balancing Healthcare and Tax Strategies
For retirees anticipating substantial medical or LTC costs, maintaining a traditional IRA can be a powerful strategy. By leveraging tax deductions and strategically timing withdrawals, traditional IRAs effectively function as a healthcare reserve.
On the other hand, Roth IRAs offer unmatched tax-free growth and withdrawal flexibility, making them ideal for estate-focused retirees or those with fewer medical needs.
Ultimately, the decision between a traditional IRA and a Roth conversion is personal, requiring a careful evaluation of healthcare projections, tax considerations, and financial goals. A consultation with us at Abound Financial can help retirees craft a plan tailored to their unique needs.
Traditional IRA as an LTC Strategy
A traditional IRA is not a substitute for long-term care insurance but can act as a practical alternative for retirees comfortable self-insuring against LTC risks.
Example: Nursing Home Costs and Tax Efficiency
- Scenario: John, age 75, withdraws $100,000 annually from his $500,000 traditional IRA for nursing home care.
- Income: Social Security and pension income total $50,000, placing him in the 12% tax bracket.
- Medical Deduction: LTC expenses far exceed the 7.5% AGI threshold, allowing him to deduct $96,250.
- Outcome: After deductions, John’s taxable income remains low, with an effective tax rate of only 6.45% on his IRA withdrawal.
Using the traditional IRA, John minimizes taxes while covering his medical expenses efficiently.
Comparison of Results: Traditional IRA vs. Roth IRA
| Factor | Traditional IRA | Roth IRA |
| LTC Withdrawal | $100,000 | $100,000 |
| Effective Tax Rate on Withdrawal | 6.45% (after deduction) | 0% (tax-free) |
| Total Tax Paid | $6,450 | $0 |
| Net After-Tax Withdrawal | $93,550 | $100,000 |
| Roth Conversion Cost (at 65) | $0 | $110,000 (one-time) |
Analysis
- Maximizing Tax Savings with a Traditional IRA:
John leverages the medical expense deduction to significantly reduce his tax burden on withdrawals from his traditional IRA. With an effective tax rate of just 6.45%, this strategy makes the most of his medical expenses and allows him to preserve more of his retirement funds. - The Cost of a Roth Conversion:
If John had converted his traditional IRA to a Roth at age 65, he would have faced an upfront tax cost of $110,000. This substantial expense reduces the overall retirement nest egg, especially if John doesn’t live long enough to fully capitalize on the tax-free growth of the Roth IRA. - Lost Deduction Opportunity:
Using a Roth IRA for LTC expenses eliminates the opportunity to offset taxable income with the medical deduction. While Roth distributions are tax-free, they don’t provide the same tax relief when paired with high medical expenses.
Conclusion
For retirees like John, who anticipate significant long-term care expenses, the traditional IRA can be a more effective choice. By taking advantage of the tax-deductible nature of medical expenses, John minimizes his overall tax liability while addressing healthcare needs.
This strategy is particularly beneficial for retirees with high medical costs and those in moderate-to-lower tax brackets. By contrast, the upfront conversion cost of a Roth IRA may outweigh its benefits in scenarios where medical deductions provide meaningful tax relief.
There is no one-size fits all answer when it comes to your particular needs. Connect with one of our advisors today if you’d like to plan for your financial future!
