What is the medical expense deduction, and why is it a big deal?

The medical expense deduction has a huge impact on long-term care, and the Republican tax bill now in Congress might eliminate it—or increase it.

As the Washington Post reports in this article, there are two versions of the tax bill being considered: the House bill and the Senate bill. The House bill would eliminate the medical deduction; the Senate bill would increase it.

Republicans are now working on reconciling the two bills. As the article notes, this issue has generated a lot of concern from lawmakers who know the impact it will have on seniors. I expect a compromise will avoid eliminating the medical deduction in the end.

Still, it’s important to know what might be coming. The problem is that IRAs and long-term care costs don’t work together very well.

What is the medical expense deduction?

For a long time, there has been a deduction in the tax code for out-of-pocket medical expenses that exceed 10% of a taxpayer’s gross income. Because 10% of gross income is usually several thousand dollars, the medical deduction is typically used by taxpayers with high unreimbursed medical expenses. The prime example: seniors needing long-term care in a nursing home.

A typical situation might look like this:

  • Mary is single, has advanced dementia, and resides in a nursing home.
  • Between social security, pension, and withdrawals from her IRA, she has $100,000 of income. (She has to withdraw a lot from her IRA to pay that $8,000-per-month nursing home bill. Withdrawals from an IRA count as taxable income.)
  • Without the medical expense deduction, Mary will likely have to pay $15,000-$18,000 of income tax on her $100,000 of income.
  • With the medical deduction, Mary’s tax will be much lower. Because all of Mary’s income goes to pay for medical expenses, she might deduct $86,000 on her income taxes. This means she’ll owe tax on only $14,000 of income instead of $100,000. She might pay $1,500 in tax instead of $15,000.

The bottom line is that Mary—and other seniors like her—is able to spend many thousands more on the care she needs instead of on government taxes because of the medical expense deduction.

Why IRAs and Long-Term Care Don’t Mix

Many seniors have most of their retirements savings in an IRA. When they end up needing long-term care, they often have no way to pay for it except to draw from their IRA. Because the bills are large, they have to withdraw large amounts. This drives their taxable income up and up.

When you can plan ahead, you can limit withdrawals from your IRA to keep the tax to a minimum. A good financial advisor will make a plan for this. But when you need to pay that nursing home bill, you have no choice and no plan.

This applies even with Medicaid. In most cases, a person with an IRA must spend their IRA down (though not their spouse’s) before applying for Medicaid. Medicaid counts the entire amount in an IRA as available to pay for care and expects you to use it. Medicaid doesn’t care how much tax you end up paying as a result.

So, many seniors with high medical bills find themselves in an unexpected situation: their taxable income is higher than its ever been because of all the money they have to withdraw from their IRAs. The medical deduction solves this problem by reducing taxable income. If that deduction weren’t available, however, it would be better to withdraw everything from the IRA earlier in life and reinvest it—that way you would have already paid the tax and could use the money freely.

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