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Exchange an Idle Non-Qualified Annuity for Tax-Free Long Term Care Coverage

David Darwish, CFP®


The rising costs associated long-term care (LTC) insurance tend to be a stumbling block for those considering purchasing coverage. But if you own a non-qualified annuity, there could be a way around that issue for you. The Pension Protection Act of 2006 altered IRS Section 1035 to allow traditional annuity and insurance policies to be exchanged on a tax-deferred basis for LTC policies. Under the new rules, 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.

For example:
You purchased an annuity for $100,000 and it is now worth $200,000. You have a $100,000 unrealized gain. If you want to access these funds for personal use or future healthcare costs, you must recognize as ordinary income the gains of up to $100,000—before you reach your basis, that is, the purchase price. If you don’t withdraw the funds during your lifetime, the assets pass to the next generation without a step-up in basis, leaving the tax liability to your heirs. But to create a tax-free benefit, you exchange the annuity for an LTC policy with a lump sum premium of up to the full value of the annuity of $200,000. The $100,000 gain is deferred on the transfer to the LTC policy, and the benefits will never be taxed. If you don’t use the LTC benefits, the death benefit of the LTC policy passes to the next generation tax free.

Typically, annuities are purchased for tax deferral and guaranteed income streams. If you pass along the annuity at your death, the deferred tax on the gains will be paid by the beneficiaries. The gains are not stepped up—that is, the purchase price is not increased to a current market value for tax purposes—at the date of death. The beneficiaries must pay the tax when the distribution takes place, making, in essence, the IRS a beneficiary of your non-qualified annuity. Depending on your heirs’ personal tax brackets, the proceeds could net them as little as 60 percent of the assets. The withdrawals could also substantially effect other taxes they pay, such as Medicare Part B and D premiums.

The insurance industry has made sweeping changes in the past 10 years to their LTC products. Traditionally, you would purchase a LTC product the same way you buy an auto or homeowners policy; if you don’t use the insurance, the premiums are lost. Now there are hybrid LTC products that offer a death benefit if the insurance is not used, and these policies could make for an appropriate use of a 1035 annuity exchange. Of course, you must determine how this strategy plays into your overall financial picture, your intended use of those idle funds, and other related concerns, all of which can be addressed through the financial planning process. So make sure you are having these conversations with your financial advisor.

If you own a non-qualified annuity and it is sitting idle, a 1035 exchanging for a hybrid LTC policy could generate a substantial financial benefit. It could be one of your best financial decisions.


The information included in this document is for general, informational purposes only. It does not contain any investment advice and does not address any individual facts and circumstances. As such, it cannot be relied on as providing any investment advice. If you would like investment advice regarding your specific facts and circumstances, please contact a qualified financial advisor.

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