Retirement is an exciting time of transition in your life! As you approach your golden years, one of the key decisions you may be contemplating is your living situation – not just for today, but with special consideration for future circumstances as well.
Class A continuing-care retirement communities can be an attractive lifestyle option for well-off retirees. Class A CCRCs offer a full range of services, from independent living to skilled nursing care. These communities offer plenty of amenities, events and other opportunities to remain social, active and healthy throughout your retirement. CCRCs are like college campuses for seniors – not to mention that if you were to stroll through some of these campuses, you might think you were at a country club!
In addition to the social benefits, continuing-care retirement communities can provide you with a more stable means of managing your long-term health care costs. When you buy into the community and pay the monthly maintenance fees, you are essentially paying up front for all of your lifetime health care services – from independent living to full care.
While most people who are considering buying into a Class A CCRC are aware of the aforementioned benefits, many people who move into a community are missing out on a little-known tax break that could significantly lower your costs. The potential tax-saving benefits of moving into a CCRC are two-fold: (1) a one-time deduction of your entrance fee and (2) an ongoing deduction of your monthly fees.
When you file your taxes for the year, you are allowed to deduct the costs as prepaid medical expenses– even if you live independently at the CCRC and require little to no care. Since the CCRC fees can be quite steep, significant write-offs may be allowed when your out-of-pocket medical expenses surpass 7.5% of your adjusted gross income based on current tax law in 2022.
How Does It Work?
The idea of prepaid medical deductions might sound too good to be true, but it has been affirmed by the U.S. Tax Court ruling in D.L. Baker v. Commissioner [122 TC 143, Dec. 55, 548 (2004)]. The Bakers won big, and the precedent set by their case is good news for many seniors. According to CPAs, the 2004 decision allows your one-time entry fee and recurring monthly charges at Class A CCRCs to be classified as prepaid medical expenses.
Even better, the amount that can be treated as medical expenses is not dependent on the level of health care services you received during a given year. Rather, the deduction is determined based on the CCRC's aggregate medical expenditures in relation to their overall expenses or revenue generated from resident fees. All Class A CCRCs should be able to provide tax information from previous years for you to evaluate.
Example – Entry Fee Deduction: Fred and Wilma Flintstone move to a Class A CCRC in 2018 and pay an entrance fee of $800,000 (non-equity plan). A large portion of the entrance fee would be deductible in the year of closing. Assuming the deduction is 45% of the entrance fee, they could be eligible for a medical expenses deduction of $360,000.
However, their adjusted gross income for 2022 was only $100,000. Without any additional planning, Fred and Wilma would end up with a negative taxable income. Although they would pay $0 in income taxes for the year (which is great), the IRS does not allow Fred and Wilma to “carry over” their negative taxable income to future tax years. Thus, if you don’t have sufficient taxable income in the year of your closing, you are effectively wasting a significant amount of the available deduction.
Note: To fully benefit from the second tax break – the deduction of your monthly fees – you will also need to continuously plan to generate enough taxable income for each year after you buy into the CCRC.
How to Create Taxable Income
One of the most beneficial methods for “creating” additional taxable income is to convert some of the assets in your traditional IRA to a tax-free Roth IRA. Although a Roth conversion typically increases your tax burden significantly, the deductions from the CCRC medical expenses may be used to offset taxes on the conversion. If done properly, you will likely pay little or no taxes on the conversion. Best of all, once the conversion is complete, the assets in a Roth IRA remain tax-free for the rest of your lifetime and the lifetime of your spouse.
Converting traditional IRA assets to a Roth IRA is not only useful for creating the large amount of income needed to fully benefit from the entry fee deduction; future conversions may also be used to generate the income needed to take advantage of the recurring annual medical expense deductions.
An added benefit of Roth IRA is the lack of required minimum distributions (RMDs) during your lifetimes. If the assets in your Roth IRA are not withdrawn during your lifetime (and perhaps even for the lifetime of your spouse), then your children or other beneficiaries will inherit those tax-free ROTH IRA assets.
With an inherited Roth, your children/beneficiaries will never have to pay taxes on your ROTH IRA assets, and there are few restrictions on how that money can be invested or used (with the notable exception that your beneficiaries will be required to take all of the money out of the account by the 10th anniversary of your passing per the SECURE Tax Act of 2019*). Simply put, converting your assets to a Roth IRA not only helps you to create income in the short term to use up the CCRC deduction; it is also a great way to compound assets tax-free for the duration of you and your spouse’s lifetime and beyond.
Another popular option for creating taxable income is to take a large distribution from a traditional IRA or a tax-deferred annuity. In the earlier example, if Fred and Wilma withdrew $360,000 from an IRA or annuity (the amount needed to make full use of the one-time entry fee deduction), they may pay little or no additional income tax on that distribution.
Of course, the best approach for optimizing your tax savings will vary based on your personal financial circumstances. A detailed review of your full financial picture would allow you to devise a plan for leveraging the assets in your portfolio in the most advantageous way possible.
Last but certainly not least: The deductions for your initial entrance fee and the ongoing monthly fees are available on a “use it or lose it” basis! In other words, you will need to plan out your taxable income every year to ensure that you receive the maximum benefit from these substantial deductions.
Because of the significant but complex planning opportunities available to individuals moving into a Class A CCRC, we strongly recommend that you seek professional advice before you make the move. A financial planner who is well-versed in the tax planning opportunities for CCRCs along with your CPA can help you to enhance your cash flow and financial positioning for the remainder of your lifetime.
*Current regulations are still pending on this portion of the SECURE ACT of 2019. One proposal suggests that your children will have to take RMD distributions each year through year 10. Stay tuned.