The Pension Protect Act (PPA) was passed by Congress in 2006 and became effective in 2010. The law provides tax advantages for consumers who wish to purchase a long term care policy using a non-qualified annuity policy.
The provision in the I.R.S tax code allowing for this is called a 1035 tax free exchange. Consumers can use this provision in different ways to purchase a long term care policy with an annuity on a tax advantaged basis.
When consumers contact our agency, they generally want to know more about the Pension Protection Act and how it might help them. In short, long term care expenses (specifically Medicaid costs) are major outlays for federal and state governments
The PPA encompasses a lot, but one major purpose was to incentivize the purchase of LTC insurance. Federal and state governments would much rather have consumers and insurance companies pay the costs of extended care than these same consumers spend down their assets and then turn to Medicaid for assistance. (Medicare only partially pays for the first 100 days of skilled nursing care, but nothing more.)
The PPA helps consumers who are interested in purchasing long term care in several ways. The primary advantage is the tax incentives provided by this law.
It also offers flexibility for those with existing assets earmarked for long term care expenses. In a nutshell, the interest gains from non-qualified annuity accounts can now be used on a tax-free basis to either fund or purchase a traditional or hybrid long term care insurance policy.
(A non qualified annuity is one where the initial investment was made with post-tax dollars. This is unlike a qualified annuity – like an IRA or 403b – where the investment was made with pre-tax dollars).
If an individual purchases long term care by simply writing a check from his or her bank account each year, then there are no taxable benefits or deductions. However, if a non-qualified annuity is used to make this same purchase, then the interest gains from the annuity can be used tax free.
There are two ways to do this. The first method is to purchase an immediate annuity and send all (or a portion) of the systematic yearly payments to the insurance company offering the LTC plan. An immediate annuity provides payments consisting of principal and interest – so long as the interest is used to pay for the LTC policy, then it would not be taxed as ordinary income. In some cases the annuity and the LTC insurance can be bundled and purchased from the same company.
The second method is to make yearly withdraws from an existing non-qualified deferred annuity that was purchased some years ago. For example, a $150,000 annuity (with a $100,000 cost basis) would have $50,000 in deferred gains. The owner could execute a partial 1035 exchange (taking out a portion of the $50,000 that would normally be taxable) and use those funds to pay for the LTC policy on a tax-free basis each year.
There are some rules that must be followed in order for these two strategies to work. The LTC policy must be “tax qualified” (most are) and the LTC provider must be able to accept the funds from the annuity subject to the I.R.S. 1035 exchange rules. If the annuity owner takes constructive receipt of the payments first, then these strategies will not work. It is important to work with a knowledgeable agency like ours when setting up these types of transactions so as to avoid taxable mishaps.
When interest rates are low, then the savings described above may not be very significant if the annuity is not generating large amounts of taxable interest. However, the 1035 exchange rule can be very beneficial if an owner of an existing annuity wants to exchange their traditional policy for a hybrid long term annuity.
Hybrid annuities are somewhat new and they are gaining popularity very quickly. Many consumers are worried about purchasing a traditional long term care policy because of costs, rising premiums and the idea that it may never be needed. Hybrid LTC annuity accounts help to avoid these issues.
Consumers can exchange an old non-qualified annuity account for a hybrid long term care annuity using the same 1035 exchange rule. When setup properly, this exchange generates no taxable gains. Using the example above, the $50,000 gains would transfer tax free to the new hybrid policy.
But wait, there’s more. The $50,000 gains could be withdrawn later on a tax free basis to cover the insured’s long term care expenses – like care in an assisted living facility, nursing home or the annuity owner’s own home. Additionally, hybrid long term care annuities will leverage the deposits by a factor of 2-3X over providing the potential for much larger LTC benefits than the policy from which they came.
This can be a very good strategy for those who have an existing annuity earmarked to pay for long term care expenses as well as for those who wish to self-insure. Why take taxable withdrawals from a non-qualified annuity to pay for LTC expenses (i.e. nursing home care) when you can take tax free withdrawals from a hybrid LTC annuity?
(It is important to note that there is some medical underwriting required with hybrid LTC annuity accounts. Consumers must purchase them while in reasonably good health – otherwise they can be declined as is the case with any health insurance policy. It is best to be proactive when purchasing LTCi.)
While somewhat less common, consumers can also use the cash value in their life insurance policy to fund a long term care policy and still be in compliance with the PPA. This would also be done using the I.R.S. approved 1035 exchange rules.
Again, it’s important that the long term care insurance company be able to accept the funds from the life insurance company as a 1035 exchange. This could be done as a lump sum (thus surrendering the life policy) or through a systematic withdrawal. When taking withdrawals from a life insurance policy, it’s important to understand how the integrity of the policy will be affected.
First, we must stress that the agents at Hyers and Associates are not tax advisors nor is this article intended to offer actionable tax advice. While we are familiar with tax rules and regulations as they apply to insurance policies, it is always advisable to talk with your own tax advisor before making exchanges.
That being said, we can help those who are interested in purchasing long term care insurance using non-qualified annuities and life insurance. The Pension Protection Act is a valuable piece of legislation incentivizing these unique transactions. Contact us today to learn more.