PPACA Opens New Door for Funding LTCi

Providing the consumer with additional ways to fund LTCi was one of the accommodations in the The Pension Protection Act of 2006 (PPACA).  Effective Jan. 1, 2010  individuals have new, tax-favored procedures for helping to pay for transferring the probable risk of long term care costs to an insurance company.

Many people have money locked up in qualified financial vehicles such as cash value life insurance policies and annuities.  Prior to the provisions of the PPACA that went into effect Jan. 1, 2010, those funds were not always available to directly fund a long-term care plan of insurance without the possibility of triggering an income-tax event on gains.  Now, those funds can be transferred or “exchanged” using  an expansion of IRS tax code 1035 to purchase several different types of long-term care insurance plans (see below for details).

If the policyowner(s) can qualify for long-term care insurance, they can roll a partial or full surrender of the cash from the life insurance policy or annuity into a single-premium, stand-alone long-term care insurance policy.  No further premiums would be required.   As good as this sounds, there are some obstacles to accomplishing this procedure:

•  The carrier underwriting the long-term care plan of insurance does not have to accept the single premium of qualified money if they choose not to.  Some carriers have announced that they won’t.  If they do, special conditions may apply. 
• At this writing, the only carriers that I know that will negotiate such a payment schedule are State Life (OneAmerica), Genworth and Mutual of Omaha.  Each has its own procedure and this option may not be available in all states or with all series of available plans of insurance.
• A carrier may accept the 1035 exchange funds as a partial single premium payment.  Any additional costs to complete the transaction – provide the necessary single premium –   would have to be payed by the insured(s) out of pocket.  They would not be able to extend payments over a future number of years.

The primary benefit to the consumer in performing such an exchange is that, if done correctly, there are no income taxes involved.  The 1035 exchange takes place between carriers and is, therefore, not reportable as taking gains. And, the tax-favored status of the long-term care policy remains intact.  So, in effect, the taxable gain of  the cash value of a life insurance policy or an annuity disappears completely.   As a result, individuals with an existing life insurance or annuity policy with a significant inside buildup of cash value  may find this an attractive way to purchase long-term care insurance.

An alternative to the single-premium payment is a  partial 1035 exchange from the life insurance policy or the annuity performed annually that would be used to pay the annual long term care insurance premium .  This has the same advantages of the single-premium procedure, but it allows for some continued, tax-deferred growth of the remaining cash values in the life insurance policy or annuity.  On the other hand,  it  risks the possibility of a) running out of  available cash value to pay premium, b) lapsing a life insurance policy and triggering an income-tax event, and c) subjecting the policyowner to probable premium increases in the future.  This type of payment schedule should be thoroughly evaluated by a long-term care specialist and a qualified tax advisor to make sure that the probablity of those contingencies are highly unlikely, given the particular financial situation of the policyowner. 

Technical information and disclaimer

The Pension Protection Act of 2006 altered the Section 1035 rules to allow traditional annuity and insurance policies to be exchanged on a tax-deferred basis for the newly approved long term care hybrid (life insurance or annuity) policies.  In addition, the Pension Protection Act authorized another new form of 1035 exchange. This permits exchanges from a life insurance or annuity policy to a stand-alone, traditional long term care insurance policy. Under the new rules of Internal Revenue Code Section 1035(a) (as established by Section 844(b) of the Pension Protection Act), individuals can complete a “like-kind” exchange from an insurance or annuity policy directly to a qualified long-term care insurance policy. The new law stipulates that the long term care insurance policy must be a “tax qualified” policy as defined under IRC Section 7702B. Today, the vast majority of policies meet these criteria. The rules also stipulate that the annuity policy must be non-qualified annuity. These are generally defined as annuities purchased with after-tax funds (as opposed to IRAs or retirement annuities that are purchased with pre-tax dollars).

In order to receive the tax-deferred treatment on the exchange, all the standard requirements of the 1035 exchange must be honored. The most significant requirement stipulates that the amounts must be assigned directly from the old life insurance or annuity policy directly to the new long term care insurance company issuing the policy. If the funds are distributed to the policy owner, they are deemed by the IRS as irrevocably distributed and the normal taxation rules apply.

To obtain the favorable tax treatment of a 1035 exchange, the company issuing the new long term care insurance policy must be willing and able to obtain the funds directly from the prior life insurance or annuity company in accordance with the rules of a proper 1035 exchange.

The primary benefit for those with an existing life insurance policy that may either have significant cash build up or is no longer needed — or for those with a non-qualified annuity that has enjoyed significant tax-free build-up — is the option of a new mechanism for paying for long-term care insurance.  The gain in the cash values of the  life policy or annuity is effectively erased.  This is significantly favorable tax treatment. In addition, the rules for tax qualified long-term care insurance stipulate that benefits are received tax-free, and there is no formal cash value from an LTC policy that could otherwise be taxable.

To meet the IRS requirements, the insurance company must comply with the 1035 exchange in order for the preferential tax treatment to apply. 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.

If consumers demand for this strategy allowable under the PPACA, it is very likely that more long term care insurance companies will implement the necessary policies, procedures, and requisite paperwork necessary to accommodate the transaction.  As indicated, some have already done so.

Source:  The American Association for Long-term Care Insurance (AALTCI) (www.aaltci.org). 

Disclaimer:  Nothing contained in this post constitutes tax advice or claims to accurately reflect tax law in all circumstances.  Specific individuals or families with special circumstances may not qualify for using this PPACA extension of IRS tax code 1035 with the life insurance policies or annuities that they currently own.  A qualified tax advisor should be consulted before making any final decision or signing paperwork authorizing the movement of tax qualified money for any reason.  Advanced marketing staff at the back office of the long-term care insurance companies can also be a good source of information and advice.