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  • Writer's pictureErin McCloskey, CFP®, EA

Talk insurance with a tax person

Updated: Feb 26, 2021

I have recently run into a couple of cases where someone was discussing a situation involving an insurance product, and they were misrepresenting a result because they were not including a tax issue.

I’m licensed to sell Life and Long-Term Care insurance and annuities and I am also a tax pro (IRS Enrolled Agent). This means when I consider the merits of an insurance product, I will want to include any tax implications. It frustrates me when insurance salespeople are getting the tax side wrong and worse, leading consumers to believe something that plainly isn’t true.

If you find the details of these examples tedious to read, just know these are the kinds of things that I would be happy to think about for you, as it is my job!

Here are the two scenarios that I encountered recently, and I’ll highlight the take-away points before giving the details below.

The first situation was a discussion on Long-Term care insurance. Takeaway point: Large medical expenses can become large tax deductions. The scary thing about cashing out a retirement plan for medical expenses should be the loss of the funds meant for living expenses or to leave to beneficiaries, not necessarily the income tax bill. That depends on the rest of your tax information so do not assume there will be a large tax burden in this scenario!

The second situation was on a strategy to use the cash value of a permanent life policy to replace distributions from an IRA (qualified retirement) account in years of negative market returns. Takeaway point: Review the account projections the salesperson presents to you very carefully. There is not an option to skip Required Minimum Distributions, and if they aren’t including those, the projection will be overvalued and optimistic.


First situation: The LTC insurance topic.

I think reviewing the potential risk of a long-term care event is vital to a good financial plan. If you cannot pay for long-term health care, there are so many insurance options, whether stand-alone or as a rider to life insurance product. Anyway, the salesperson was rightly saying that if you have to cash out your traditional 401k or IRA retirement fund for the long-term care costs, you would have to pay income taxes on those distributions.

But what he failed to discuss was that, if you are greatly increasing your annual income with these distributions for a medical cost, then you are probably erasing a good amount if not all of your income tax bill because of the deductibility of medical expenses.

The risk that an advisor ought to communicate should be “cashing out the retirement account for medical expenses”, not “paying income tax on the distributions for medical expenses”. There is a balance between your usual income, the tax you pay, the deductions you can take and the amount of medical expenses that should be considered on a client-by-client basis.

Back-of-the-envelope example: Your usual retirement income (Social Security and your usual IRA distribution) is $90,000. You have a long-term care need of $8,000 for 10 months and take that out of your IRA, along with your usual distribution. The medical expenses are now $80,000, and your adjusted gross income (AGI) has ballooned to $170,000. You can deduct medical expenses above 10% of AGI; in this example you can deduct $63,000! It is clear in my example that you are not going to owe ANY income tax.

The bad part is that you took the distribution instead of being able to spend it on regular living expenses or leave it to beneficiaries, not the tax bill!

I really hate to think of the salesperson who was using this scare tactic of the tax bill to encourage people to get LTC insurance. Don’t get me wrong, LTC insurance can save a financial plan… but make sure you discuss your situation with someone who can also review the tax implications for you when you want to get LTC insurance.


Second situation: The cash value → IRA distribution strategy.

A sales rep sent me a chart illustrating a person’s retirement account, the return on the account each year and the distribution. It had the person taking a certain percentage and adding a little each year for inflation. They were showing that this person also has an insurance policy with a cash balance, which can be used in the form of a loan or a distribution.

The rep was addressing an important risk in retirement which is the sequence of returns. Basically, if you have negative returns on your investment when you are early in retirement, but are still needing to take your distributions for your living expenses, you may deplete the account balance many years too early because the account shrinks too much to grow back to what you need for your lifetime income in years of positive market returns. (Yes, I should make a blog post on this topic.)

Anyway, the sales illustration showed that in the years where the IRA account took a loss on the investment, the model showed a $0 distribution from the account and instead took the living expenses from the cash value on the insurance policy, thus allowing the account to have those funds to grow in years of positive market returns. The result was that the example IRA account was protected from cashing out during the years when its balance contracted, and later grew to be worth millions.

But, there were no Required Minimum Distributions (RMD) taken in the model, and that means that this is an impossibility. RMDs are required after you turn 72 (the rule changed in 2019 from the former age of 70.5) because they are just that; required amounts you MUST take from your traditional 401k or IRA account (Roth accounts do not have RMD because you already paid income tax on your contributions). So this trick of taking $0 is not a thing you can ever do if you are past 72 years old. It works if your expenses needed are more than your RMD, and then you can take the difference from the cash account… but again this depends on how much the accounts are, your age, the need for the money. You get the point!

It can be invaluable to have someone who understands taxes to review the options with you when making decisions on these products and how they will work in your specific case, taking the whole picture and looking through the sales pitch. Your best interest should be first!


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