Secure 2.0 rules allow early 401(k) withdrawals from LTC insurance

Workers may have a new way to prepare for largely unpredictable health-related expenses during their golden years.

Under new rules now in effect, 401(k) plans allow participants to take limited, penalty-free withdrawals to pay for long-term care insurance. Long-term care insurance covers the cost of assistance with activities of daily living, such as bathing, dressing, and eating, which are often needed later in life. The new rules were included in the 2022 Retirement Act, known as the Secure Act 2.0, with an effective date of December 29, three years later.

However, it has its limitations. Experts say it’s important to consider whether it makes sense to use retirement savings to pay for long-term care insurance, or whether you should buy insurance at all.

“(The rules) are there for people, but it may not be practical to take advantage of them,” said Carolyn McClanahan, a physician and certified financial planner based in Jacksonville, Florida. She is a member of CNBC’s Financial Advisory Council.

Generally, if you make a withdrawal before age 59 1/2, you’ll be subject to a 10% penalty in addition to regular taxes. There are already several exceptions where penalties do not apply, including eligible births and adoptions, some unpaid medical expenses, and the so-called 55-year-old rule, which applies if you retire after age 55.

According to 2020 estimates from the U.S. Department of Health and Human Services, once you reach your 65th birthday, you have an approximately 70% chance of needing some type of long-term care services or support. On average, women need care for longer: 3.7 years compared to 2.2 years for men. One-third of 65-year-olds will not need long-term care, but 20% will need it for five years or more.

But Medicare, which begins at age 65 for most people, typically doesn’t cover such medical care. Unpaid family members often serve as long-term caregivers, but more formal arrangements may be required, and these paid options can be expensive.

For example, the cost of a home health aide reached a median annual cost of $77,792 last year, a 3% increase from 2023, according to the 2024 Cost of Care Study conducted by Genworth Financial. The national median annual cost of a semi-private room in a nursing home rose 7% to $111,325 starting in 2023. For private rooms, the median annual cost rose 9% to $127,750.

Options for covering these unpredictable costs range from self-insuring (being wealthy enough to pay out of pocket if such costs occur) to qualifying for Medicaid, which covers long-term care for individuals with little or no financial means.

McClanahan, founder of Life Planning Partners, said it’s more common for people between the two extremes to have some form of insurance. But traditional long-term care insurance can have a lengthy claims process, and premiums tend to be higher for better coverage, she said.

For pure long-term care insurance, a 55-year-old man with $165,000 in coverage and 3% annual inflation (meaning benefits increase by that amount each year) would pay an average annual premium of $2,200, according to the National Long-Term Care Insurance Association. For a policy that increases benefits by 5% per year, the cost would be $3,710 per year.

Women, who tend to live longer, face higher prices. A 55-year-old woman pays an average of $3,750 per year for $165,000 in premiums and 3% annual growth. A 5% increase in benefits would cost $6,400 a year in premiums, the association said.

Insurance companies can increase premiums each year.

McClanahan said many people end up purchasing hybrid insurance. This is typically a life insurance policy with a long-term care rider. In other words, some of your long-term care costs will be covered, but if you don’t use some or all of your long-term care benefits, the money may go to your beneficiary.

In contrast, pure long-term care insurance has no guarantee of payment. If you die without taking advantage of any of the benefits of your policy, you effectively lose the money you paid in premiums.

“People don’t want to go for traditional policies because they cost a lot of money and they go away when you die,” McClanahan said. “Hybrid insurance coverage is not as extensive as regular long-term care insurance, but it is still a significant amount of money available for long-term care.”

While businesses and insurers are awaiting guidance from the IRS regarding the exact parameters and application of the provisions that will take effect for penalty-free withdrawals, there are some known limitations.

First, not all 401(k) sponsors, or employers, will allow this in their plans. Alexander Papson, CFP and fiduciary solutions manager at Schneider Downs Wealth Management Advisors in Pittsburgh, said this is not mandatory and meaningful implementation may take time.

“Just because this has come up as an option to allow it doesn’t mean all (plans) have gone through the process of amending their planning documents to allow it,” Papson said.

If permitted, withdrawals are limited to the annual premium, up to a maximum of $2,600 in 2026 (indexed annually for inflation). However, the amount you withdraw cannot exceed 10% of your balance. So if you have $20,000 in your account, your withdrawals will be limited to $2,000.

Additionally, funds withdrawn will not be subject to the 10% early withdrawal penalty that typically applies to distributions taken before age 59 1/2, but will still be subject to ordinary income tax rates, said Bradford Campbell, a partner at the Washington law firm Faegre Drinker Biddle & Reese.

So if you withdraw $2,600, you won’t have to pay the $260 penalty (10%). The exact amount of tax you pay depends on your tax bracket. A person in the 12% bracket would pay $312 in taxes, and a person in the 32% bracket would pay $832 in taxes.

But those in the 12% bracket may not actually be able to afford the premiums, and those in the 32% bracket are more likely to be able to afford the premiums without dipping into their retirement savings, McClanahan said. Withdrawing money from a retirement account also means getting rid of assets that would have continued to grow tax-deferred.

Additionally, there is uncertainty as to whether the entire premium of a hybrid policy will be covered, or only the portion of the premium that covers the long-term care rider.

There are also requirements related to providing proof from your insurance company that you have paid premiums for eligible insurance policies.