Transform your parents’ medical bills into tax-free retirement savings
According to the American Association of Retired Persons (AARP), nearly 23 million households are caring for an adult over the age of 50. This number will likely increase in the future thanks to both the aging U.S. population and our increasingly longer life spans.
For many of my clients, the reality of caretaker means assisting with their ailing parents’ finances. While helping your parents pay their bills and ensuring essential estate-planning documents are in place are often top of mind, there can be a lack of execution on more tactical planning opportunities. One commonly missed benefit is when medical bills increase over time and create tax deductions that potentially go unused.
As financial caretaker, your intimate knowledge puts you in a position to create a stronger financial situation for an aging parent and potentially preserve more assets in their legacy plan.
Understanding the medical-expense deduction
For individuals age 65 and older, the IRS allows you to deduct qualified medical expenses as an itemized deduction to the extent that they exceed 7.5% of your Adjusted Gross Income (AGI), although this percentage is scheduled to increase to 10% in 2017.
For example, if an 80-year-old has an AGI of $50,000 and $7,500 of medical expenses, he could deduct $3,750 ($7,500 less 7.5% of his AGI, which is $3,750). If you are under age 65, the AGI limit is already 10%.
Throughout most of one’s working life, exceeding these limits is difficult since the AGI percentage in dollar terms is high and youth helps you avoid major medical events. Plus, the pool of potential deductible expenses is often limited to deductibles and out-of-pocket costs.
When retired, however, incomes often decrease, meaning the AGI percentage decreases in dollar terms while the likelihood of a medical event increases. You’re also able to deduct a greater variety of medical expenses: Medicare premiums, supplemental policy premiums, prescription medications, dental costs, and increasing frequent of out-of-pocket expenses.
As your parents age and you become more involved with paying their bills, it’s important to recognize if these medical bills start to create a potentially sizeable deduction. In this case, your parents’ income and deductions may end up creating negative taxable income. Sounds great right? Not necessarily.
Yes, having a negative income means no taxes, but it also means you also have excess deductions that went to waste. Unfortunately, these unused deductions do not roll over into the next tax year or roll back to a prior year (unless a business loss contributed to the negative income).
Avoid negative income by converting to a Roth IRA
One smart way to fully utilize larger medical deductions is by converting tax-deferred dollars in an IRA into a Roth IRA.
Let’s imagine John is helping his widowed, ailing mother Agnes with her finances. For the past few years, Agnes’s health was consistent, and she always paid tax on her pension, Social Security and investment income. When she turned 88, Agnes needed hip replacement surgery, started new medications and made multiple trips to the dentist. While paying her bills, John noticed that she accumulated $50,000 in medical bills.
In a normal year, Agnes’s AGI is $40,000 and she claims the standard deduction, leaving her with a taxable income of $30,000. This year, however, John estimates that she has $65,000 of itemized deductions which creates negative taxable income of ($25,000). Without any planning, this opportunity will go to waste.
To utilize these potentially unused deductions, it may be beneficial to convert money from Agnes’s IRA to a Roth IRA. This year, Agnes could convert $25,000 without incurring any taxes. The conversion is a win-win scenario. Agnes avoids at least $5,000 of taxes and has relocated $25,000 into an account that she continues to own and never has to pay taxes on (assuming she meets the qualified Roth IRA distribution requirements). From John’s perspective, if Agnes doesn’t need the funds and he inherits the IRA, the conversion will potentially save him over $7,000 in future taxes (since he is in the 28% tax bracket).
Beyond just soaking up the negative taxable income, it may also make sense to fill up the 10% and 15% tax brackets. Depending on the IRA owner’s and beneficiary’s age, health, tax situation, cash flow needs and net worth, it may be advantageous for the aging parent to execute Roth IRA conversions to maximize the amount of wealth for the owner and the eventual beneficiary of the IRA.
Being responsible for an aging parent’s finances is a stressful task. All too often this stress results in a lack of action. As your caretaking responsibilities evolve, be mindful of what’s happening in the moment. Take advantage of opportunities as they present themselves before the chance to utilize them is lost.
Source: Market Watch