Trading Your Annuity For Long Term Care Insurance

On Aug. 17, 2006, President George W. Bush signed a bill that could permanently change the way long term care insurance is sold. Although the Pension Protection Act of 2006 (PPA) became law more than three years ago, most of its long term care insurance provisions took effect Jan. 1, 2010 — meaning we’re going to begin seeing the effect of this legislation over the next 11 months.

The PPA not only provides tax clarification of long term care insurance (LTCI) combination policies, but also the ability to pay LTCI premiums in a tax-advantaged way using life insurance or annuity cash values. (Please note that, throughout this article, the referenced life and annuity contracts are purchased with after-tax dollars, meaning they’re non-qualified policies. Also, note that, to qualify for the tax advantages in PPA, any LTCI policy or rider must be qualified, per the Health Insurance Portability and Accountability Act [HIPAA].)

How the PPA treats combo products
Before the PPA, the tax treatment of life/long term care combination policies could be cumbersome. The IRS viewed the life insurance policy and the LTCI component as two separate contracts, and combination policy owners could receive a 1099 tax notice for LTCI costs paid within the life contract. The PPA clarifies that, effective Jan. 1, 2010, the LTCI cost can be paid on a tax-free basis for linked benefit life (or annuity) contracts purchased Jan. 1, 1997 or later.

In addition, the tax treatment of annuity/long term care combinations was unclear before the PPA. The PPA, however, makes it clear that LTCI benefits paid from an annuity combination policy purchased after Jan. 1, 1997 are tax-free, as long as the benefit doesn’t exceed the greater of the actual cost of long term care or that year’s daily benefit cap prescribed in HIPAA for taxation purposes. Also, as with combination life/LTCI policies, the internal transfer to pay the LTCI cost in an annuity/LTCI is tax-free.

The PPA, then, allows clients to use money currently held in annuities or life insurance contracts for LTCI premiums, and on a tax-free basis. Here are the options, with some important caveats:

  • Upgrade, and add an LTCI rider to a standalone policy
  • Do a partial Section 1035 exchange, using the proceeds to pay for a standalone LTCI policy
  • Do a full 1035 exchange into a new life combination or annuity combination policy with an LTCI rider

While 1035 exchanges offer the opportunity for tax savings and ease of premium payment, agents should be aware that there may be adverse consequences. For example, surrender charges may apply to 1035 exchanges from a life or annuity contract. If you are doing an annual partial 1035 from a life insurance contract in order to fund an annual LTCI premium, clients will want to put enough cash into the policy to avoid a contract lapse, even though the distribution is tax-free.

Doug Burkle, the linked benefits product development leader for Genworth Financial, explains some of the fine print of a Section 1035 exchange “Although you can ‘1035’ life insurance proceeds into an annuity [with an LTCI rider], you can’t swim upstream and ‘1035’ an annuity into a life insurance contract,” Burkle said.

Why combo products may be the answer
What else is in the PPA that the LTCI agent needs to know? Carl Friedrich, consulting actuary and principal with Milliman Inc., said, “There are still some advantages to a standalone LTCI policy over a combination plan, such as the fact that the medical expense deduction is not allowed for LTCI charges within an annuity or life combo product, while premiums for standalone LTCI policies may be used for those individuals who utilize these itemized deductions to the extent allowed by IRS limitations based on age.”

Nonetheless, he said, combination products do have many compelling characteristics, including an attractive pricing structure, that can make them a good choice for many consumers.

What are some of the big sales opportunities the PPA brings?
“One of the concerns many people have about holding a regular annuity is the inevitable tax bill they will incur upon withdrawal or their beneficiaries will incur upon death,” Burkle said.

“By doing a 1035 exchange of an annuity for a linked benefit annuity product, the policyholder can get the otherwise taxable growth out in a more tax-efficient way if a portion or all of the gains in the contract are paid out as tax-free LTCI benefits.”

In fact, said Burkle, there are only two tax-free ways to find tax-deferred growth in a single premium deferred annuity: through a 1035 exchange to a linked benefit annuity contract coupled with a longer long term care event, or through a a partial or full 1035 exchange to a standalone LTCI contract.

Stalling objections
PPA may also allow agents to more effectively overcome objections from consumers such as, “I’ll self-insure” or “I’ll never use the policy and will have wasted my money on premiums.”

Self-professed self-insurers can easily be shown how repositioning a small portion of their “self-insuring” investment into a combination product is a better option for them.

If you are meeting with someone who doesn’t have liquid assets to pay premiums, you may now have the opportunity to use money sitting in a life or annuity contract to take care of their long term care financing problem.

Is the PPA going to be a boon for the LTCI industry? Whether the answer is “yes” or “no,” it’s clear the act will give many agents additional options and opportunities to help prospects take care of their long term care risks.

For a FREE, NO HASTLE, examination of this strategy email or call Craig E Lewis, CFP at:  or  770-287-4933.

2 Examples of LTC Combo Policies Female, age 60; single premium of $100,000
Single premium deferred annuity with LTCI
LTC initial coverage (not including annuity value): $200,000
($645,020 projected coverage net of annuity value at age 85)LTCI initial monthly maximum: $2,778 (projected $8,958 at age 85)Coverage begins: Two years from effective policy dateElimination period: Two years

Guaranteed annuity surrender value: $141,682 at age 85 (illustrated at $212,193)

  • Covered long term care withdrawals first reduce value of annuity policy, then long term care coverage; there are no surrender charges for covered long term care withdrawals
  • Five percent compound inflation on LTCI monthly maximum
  • Value of annuity policy grows with interest; the policy value also covers the cost of long term care benefits
  • No-lapse guarantee on long term care benefits
  • LTCI rates guaranteed for first five policy years
  • Long term care monthly charge waived from first day of home or facility care
Single premium life insurance with LTCI
Death benefit payable at end of first policy year: $259,319 (preferred rate class)Total long term care coverage: $518,638 (not including accelerated benefit rider, which is paid from life insurance death benefit); this amount is an extension of the benefits riderInitial monthly LTCI maximum: $10,805 (projected and guaranteed); guaranteed drops to $7,949 at age 85, while projected remains level at $10,805Elimination period: 90-day for facilities; none for home care

Guaranteed death benefit (minimum interest rate and maximum insurance charges): $259,319 until age 85; $190,787 ages 85 through 119

  • Covered long term care withdrawals first reduce life insurance, then long term care coverage.
Policy values provided by Genworth Life Insurance Company