New Rules Allow Withdrawals from 401(k) for Long-Term Care Insurance

Workers now have a new option to plan for unpredictable health-related costs during retirement. Recent changes to 401(k) plans permit participants to make limited, penalty-free withdrawals to fund long-term care insurance. This insurance helps cover costs associated with daily living assistance, like bathing, dressing, and eating, which many may require as they age. The new provisions were part of the Retirement Act of 2022, although the implementation date was postponed to December 29th.

That said, it’s essential to think carefully about whether tapping into retirement savings for this purpose is a good idea, or even if purchasing insurance is necessary at all. “It’s a complex consideration,” says Carolyn McClanahan, a physician and certified financial planner based in Jacksonville, Florida.

Typically, withdrawals made before age 59 ½ incur a 10% penalty, alongside regular taxes. There are exceptions to this rule for circumstances like qualified births, adoptions, certain unreimbursed medical expenses, and a provision for those who leave their job after turning 55.

Rising Costs of Long-Term Care

As it stands, there’s a significant likelihood—around 70%—that you’ll need some form of long-term care once you hit 65, according to the U.S. Department of Health and Human Services. Women generally require care for longer (about 3.7 years) compared to men (2.2 years). While about a third of 65-year-olds may not need such care, 20% could require it for five years or longer.

It’s worth noting that Medicare, which kicks in at age 65 for most, typically doesn’t cover these types of expenses. Often, family members step in as caregivers, but sometimes paid arrangements turn out to be necessary, and those can be costly.

For instance, the median annual cost for a home health aide reached $77,792 last year, marking a 3% increase from the previous year. Similarly, the cost for a semi-private nursing home room rose by 7% to $111,325, while a private room now costs about $127,750 annually.

People have a variety of options for managing these unpredictable expenses. Some might self-insure if they have the wealth to cover costs, while others may qualify for Medicaid, which assists those with limited financial means. McClanahan notes that many find themselves somewhere in between, likely possessing some form of insurance. However, traditional long-term care policies often come with lengthy claims processes and higher premiums for better coverage.

High Insurance Premiums

A typical long-term care insurance policy can set a 55-year-old man back an average of $2,200 per year for $165,000 in coverage and a 3% annual inflation increase. If benefits were to increase by 5% each year, the annual premium would rise to $3,710. Women, facing longer lifespans, generally pay even higher premiums—averaging $3,750 annually for similar coverage with a 3% increase, and up to $6,400 yearly for a 5% boost.

Insurance companies also reserve the right to raise premiums annually, adding another layer of complexity to the decision-making process.

Many choose hybrid insurance, which combines life insurance with long-term care coverage. This means that if the long-term care benefits aren’t fully used, the remaining funds can be passed to beneficiaries. In contrast, pure long-term care insurance often doesn’t provide a payout if you don’t utilize your benefits.

Limitations of Secure 2.0 Rules

While there’s anticipation among businesses and insurers for IRS guidance on the specifics of these new, penalty-free withdrawals, there are known restrictions. Not every 401(k) sponsor will include this option in their plans, and as Alexander Papson from Schneider Downs pointed out, it’s not a given that implementation will occur quickly.

Even if allowed, withdrawals are restricted to annual premiums capped at $2,600 by 2026 (adjusted annually for inflation) and can’t exceed 10% of your account balance. So, for instance, a $20,000 balance allows for withdrawals up to $2,000.

Funds withdrawn won’t incur the typical 10% early withdrawal penalty, but they will be subject to ordinary income tax. So, if a person withdraws $2,600, they avoid a $260 penalty but will owe taxes based on their tax bracket, which could range from $312 to $832 depending on their situation.

However, those in lower brackets may struggle to afford the premiums, while individuals in higher brackets might manage without dipping into their retirement savings. Taking money out now means sacrificing future growth potential.

Additionally, it’s unclear whether the entire premium for a hybrid policy qualifies or just the portion that pertains to long-term care. Proof of paid premiums may also be necessary.