Paying For Long-Term Care Insurance With A 1035 Exchange

Author: Michael Kitces

Team Kitces

Michael Kitces is Head of Planning Strategy at Buckingham Strategic Wealth, which provides an evidence-based approach to private wealth management for near- and current retirees, and Buckingham Strategic Partners, a turnkey wealth management services provider supporting thousands of independent financial advisors through the scaling phase of growth.

In addition, he is a co-founder of the XY Planning Network, AdvicePay, fpPathfinder, and New Planner Recruiting, the former Practitioner Editor of the Journal of Financial Planning, the host of the Financial Advisor Success podcast, and the publisher of the popular financial planning industry blog Nerd’s Eye View through his website Kitces.com, dedicated to advancing knowledge in financial planning. In 2010, Michael was recognized with one of the FPA’s “Heart of Financial Planning” awards for his dedication and work in advancing the profession.

Read all of Michael’s articles here.

The Pension Protection Act of 2006 brought about several changes to the long-term care marketplace. It altered the tax treatment of so-called "hybrid" life/LTC and annuity/LTC policies, allowing benefits to be received tax-free even while premiums are extracted from the policy without being taxed as a distribution (instead they reduce cost basis). It also altered the Section 1035 rules to allow traditional annuity and insurance policies to be exchanged on a tax-deferred basis for the newly blessed hybrid policies. But in a little known provision, the Pension Protection Act authorized another new form of 1035 exchange: not merely going from a life or annuity policy to a hyrbid LTC policy, but also exchanging a life or annuity policy for a standalone, traditional LTC policy.

Technical Rules For 1035 Exchanges

Specifically, under the new rules of IRC Section 1035(a) (as established by Section 844(b) of the Pension Protection Act), which first took effect in 2010, individuals can complete a "like-kind" exchange from an insurance or annuity policy directly to a qualified long-term care policy. The rules stipulate that the LTC policy must be a "qualified" policy as defined under IRC Section 7702B (which generally describes all typical LTC policies issued today that provide tax-free benefits). On the other hand, the annuity policy must be non-qualified (i.e., purchased with after-tax funds; money from a retirement account that happens to hold an annuity is still subject to standard retirement account rules).

In order to receive the tax-deferred treatment on the exchange, all the standard requirements of the 1035 exchange must be honored - most significantly, that the amounts must be assigned directly from the old (life/annuity) policy to the new (LTC) policy. If the amounts are distributed to the policyowner, they are irrevocably distributed and the normal taxation rules apply; a 1035 exchange cannot be completed by simply replacing the funds in a new policy in a limited period of time, the way an IRA rollover can. Thus, in order to obtain the favorable tax treatment, the company issuing the new LTC policy must execute the transaction by obtaining the funds directly from the prior life/annuity company in a proper 1035 exchange.

Application Of The New LTC Insurance 1035 Exchange Rules

With the new 1035 exchange rules, clients have a new mechanism for paying for long-term care insurance - to use the cash value from an existing life or annuity policy (presumably one that is no longer needed in its original form!). What's notable about completing the transaction via a 1035 exchange, though, is that it can allow clients to not just defer the gains in the life insurance or annuity policy, but to permanently avoid them and effectively use all of the gains pre-tax to fund LTC insurance.

The reason for this more favorable treatment is the reality that while the new 1035 exchange rules merely stipulate that a transfer from an existing life or annuity policy will be tax-deferred, the existing rules for qualified long-term care insurance stipulate that benefits are tax-free, and there is no formal cash value from an LTC policy that could otherwise be taxable. As a result, the gain effectively is not just deferred, but disappears entirely.

Thus, for example, a client with an annuity worth $97,000 that was originally purchased for $50,000 - facing a gain of $47,000 - could exchange the annuity policy for a $97,000 single premium LTC policy (obtaining whatever daily benefit, benefit period, and other features are available at a $97,000 price point). The $47,000 gain is deferred on the transfer into the LTC coverage, but the LTC benefits will be paid tax-free if/when there is a claim. As a result, the $47,000 gain is never taxed. By comparison, the alternative strategy - to take withdrawals from the annuity to pay for the LTC coverage - would result in taxable income to the extent of gain every year under IRC Section 72(e)(3), to be offset by any available tax deductions for the LTC insurance. Except given the constraints on LTC deductions for individuals - available only as an itemized deduction, limited to only the age-based premiums specified by IRC Section 213(d)(10), and then still only deductible to the extent costs exceed 7.5%-of-AGI when combined with other medical expense deductions - most clients effectively would report income on the annuity withdrawal, and little or no deduction for the LTC coverage. As a result, withdrawing from an annuity to pay LTC coverage makes the entire payment "after-tax" whereas the annuity-to-LTC 1035 exchange is entirely "pre-tax" (since the gains are deferred and never recognized!).

Unfortunately, though, one major issue in recent years has arisen that makes this strategy difficult to implement - due to ongoing challenges in the LTC marketplace, almost no single-premium LTC policies are available for purchase today. As a result, while the tax code allows an exchange from a life or annuity policy into an LTC policy, there are no such LTC policies available to buy! However, there is a workaround: the partial 1035 exchange.

Partial 1035 Exchanges Into Long-Term Care Insurance

The partial 1035 exchange - where only a portion of an existing life or annuity policy is surrendered to exchange to a new annuity policy - has been allowed with some caveats for more than a decade now. The current guidance, under Revenue Procedure 2008-24, as modified by Revenue Procedure 2011-38, was drafted originally for annuity-to-annuity exchanges, but is generally viewed as being equally valid for annuity-to-LTC exchange as well.

Under the current partial 1035 exchange rules, any partial transfer will result in a pro-rata allocation of cost basis between the old contract and the new contract. Thus, for example, if the client in the earlier example transferred only $5,000 out of the $97,000 contract - which constitutes $5,000 / $97,000 = approximately 5.15% of the value - then an equivalent 5/97ths of the $50,000 cost basis would also transfer over. Thus, if the client moved $5,000 from the $97,000 annuity with a $50,000 cost basis, the payment would constitute $2,577.32 of basis and $2,422.68 of gain, and the original annuity would be down to $47,422.68 of cost basis (and given a remaining contract value of $92,000 after the withdrawal, the remaining gain would be $44,577.32.

In practice, this means that each $5,000 exchange out of the existing annuity contract - e.g., as an annual 1035 exchange payment to a new long-term care insurance policy - would be the equivalent of $2,422.68 of pre-tax gain and $2,577.32 of after-tax cost basis. Of course, the calculations would be updated each year as the amount of gain in the annuity was adjusted in light of investment returns.

The New LTC 1035 Exchange In Practice

Given the general lack of single-premium LTC policies and the fact that most LTC coverage is purchased under a policy with annual premiums, most clients will take advantage of the new rules by making systematic partial 1035 exchanges from an existing life or annuity policy. The greater the embedded gains in the policy, the greater the appeal to do such exchanges, because larger gains mean a larger portion of each exchange payment that constitutes a pre-tax payment of LTC coverage.

On the other hand, it's notable that if the client actually does have enough medical expense deductions to meet the 7.5%-of-AGI threshold, then at least a portion of the policy will be tax deductible under current law (although note it's a 10%-of-AGI threshold for clients subject to the AMT). In such situations, it will be necessary to compare whether the portion of the premium deductible by paying directly (up to the IRS premium limits) is more or less favorable than extracting a partial exchange from an available life or annuity policy with gains. Any available state long-term care insurance deductions or credits should also be accounted for, although notably there is little available guidance from states about whether a partially-pre-tax exchange payment under Section 1035 would qualify for the same potential state tax deductions or credits that a traditional after-tax payment would allow (while the general rules of taxation discourage such "double dipping", not all state laws expressly forbid it in this context, leaving some gray area). Fortunately, the decision about whether to fund LTC insurance from after-tax payments or via 1035 exchanges, based on the details of tax treatment available in that particular year, can be made on a year-by-year basis.

A more practical but important constraint to the strategy is the fact that not all long-term care insurance companies are fully prepared to allow for funding via 1035 exchanges. Notably, the insurance company must comply with the 1035 exchange in order for it to occur, as the amounts must technically be assigned from the old life/annuity policy to the new insurance company for payment into the new policy, which the new insurance company must handle directly. If the insurance company is not prepared and/or does not know how to process the 1035 exchange properly, it is not available as a payment mechanism. On the plus side, some LTC insurance companies have stepped up; the most recognized leader in this area is Genworth, which actually has a form to establish an ongoing annual partial 1035 exchange up front, for some or all of the LTC premium, potentially limited by any surrender charge/free withdrawal amount constraints (if desired). As partial 1035 exchanges become more popular, it is very likely that more companies will implement the necessary policies, procedures, and requisite paperwork necessary to accommodate the transaction.

The bottom line is that while the client circumstances may vary - and some may simply get a sufficient tax benefit by paying long-term care insurance under normal means - the new rules from the Pension Protection Act that took effect in 2010 provide the only means available today to actually liquidate an annuity with a gain while avoiding the tax consequences forever! As a result, it's a nice alternative for clients who have existing, but no longer necessary, annuity (or life) policies with significant gains, who are looking for a means to fund traditional long-term care insurance.