Nothing can throw a monkey wrench into an estate plan like incurring long-term care (LTC) expenses. These expenses — for nursing home stays, assisted-living facilities, home health aides and other care — can quickly deplete funds you’ve set aside for retirement or to provide for your family after your death.
An LTC insurance policy can offset these costs, but the premiums can be expensive — especially if you wait to purchase it at or near retirement age. One potential source for funding LTC insurance premiums is a total or partial tax-free exchange of an existing life insurance policy or annuity contract.
Road to tax-free exchanges
For many years, Internal Revenue Code Section 1035 has permitted taxpayers to exchange one life insurance policy for another, one annuity contract for another, or a life insurance policy for an annuity contract without recognizing any taxable gain. (Sec. 1035 doesn’t permit an exchange of an annuity contract for a life insurance policy.)
In the late 1990s, the U.S. Tax Court approved partial tax-free exchanges, finding that these exchanges satisfy the requirements of Sec. 1035. A partial exchange might involve using a portion of an annuity’s balance or a life insurance policy’s cash value to fund a new contract or policy. For a transaction to be tax-free, the exchange must involve a direct transfer of funds from one carrier to another.
The Pension Protection Act of 2006 expanded Sec. 1035 to include LTC policies. So now it’s possible to make a total or partial tax-free exchange of a life insurance policy or annuity contract for an LTC policy (as well as one LTC policy for another). Keep in mind that, to avoid negative tax consequences after making a partial exchange of an annuity contract for an LTC policy, you must wait at least 180 days before taking any distributions from the annuity.
Understanding the benefits
A tax-free exchange provides a source of funds for LTC coverage and offers significant tax benefits. Ordinarily, if the value of a life insurance policy or annuity contract exceeds your basis, lifetime distributions include a combination of taxable gain and nontaxable return of basis. A tax-free exchange allows you to defer taxable gain and, to the extent the gain is absorbed by LTC insurance premiums, eliminate it permanently. Consider this example:
Tim, age 75, is concerned about possible LTC expenses and plans to buy an LTC insurance policy with a premium of $10,000 per year. He owns a nonqualified annuity (that is, an annuity that’s not part of a qualified retirement plan) with a value of $250,000 and a basis of $150,000, and Tim wishes to use a portion of the annuity funds to pay the LTC premiums. Under the annuity tax rules, distributions are treated as “income first.” In other words, the first $100,000 he withdraws will be fully taxable and then any additional withdrawals will be treated as a nontaxable return of basis.
To avoid taxable gain, Tim uses partial tax-free exchanges to fund the $10,000 annual premium payments. In an exchange, each distribution includes taxable gain and basis in the same proportions as the annuity: In this case, the gain is ($100,000/$250,000) × $10,000 = $4,000. Thus, each partial exchange used to pay LTC premiums permanently eliminates $4,000 in taxable gain.
Partial tax-free exchanges can work well for standalone LTC policies, which generally require annual premium payments and prohibit prepayment. Another option is a policy that combines the benefits of LTC coverage with the benefits of a life insurance policy or an annuity.
Typically, with these “combo policies,” the death or annuity benefits are reduced to the extent the policy pays for LTC expenses.
Preserving your wealth
According to the Genworth 2015 Cost of Care Survey, at least 70% of people over the age of 65 will require some level of LTC service. LTC insurance can be an effective way to protect your nest egg against LTC expenses and preserve it for the next generation. And a tax-free exchange can be a cost-efficient strategy for funding LTC premiums. Discuss your options with your estate planning advisor.
