Section 1035 alternatives for long-term care protection

I’m going to go out on a limb and guess that your clients are like mine in that they do not enjoy paying taxes.

That might not be a stretch, and this probably isn’t either: Another common trait among our current and future clients is that many have not prepared adequately for long-term care (LTC). While these two characteristics may not seem connected, together they can actually represent a significant opportunity for you to address a glaring retirement risk with your clients.

We’ve all seen the statistics that prove the need for long-term care protection. The National Clearinghouse for Long-Term Care Information declares that around 70 percent of Americans over the age of 65 will require some type of care. Despite this, LIMRA estimates that only around 7 million have long-term care insurance in place.

My personal philosophy is that LTC is a topic too important to ignore, and I constantly express that viewpoint to my clients. Sometimes they are ready to face this issue and sometimes not, but I never stop bringing it up. It’s that crucial. I’ve also learned over my career that creativity is important, and in today’s challenging times, it is more important than ever. We have to constantly be thinking about how we protect and prepare our clients for the future, along with the suitable means to do so. There’s certainly more than one way to meet this challenge, and my clients appreciate options and outside-the-box thinking.

Here’s a creative way that your clients’ disdain for paying taxes and the importance of preparing for long-term care can intersect. Several big changes have taken place recently in the LTC marketplace, including the passage of the Pension Protection Act, the rise of new approaches to funding long-term care and recent clarification from the Internal Revenue Service. In particular, these changes have converged to create an opportunity to use an Internal Revenue Code Section 1035 exchange to address potential long-term care funding needs.

If you have clients with existing cash value life insurance and/or non-qualified annuities, there may be attractive ways to provide LTC protection with tax advantages and an avoidance of out-of-pocket premiums. The best part is that there are several different ways to approach this.

Please keep in mind that anytime one considers a 1035 exchange, the present benefits and protection provided by the current coverage will need to be fully reviewed and weighed before making a recommendation. All aspects of the current policy must be considered to enable one to determine whether a 1035 exchange is suitable and appropriate for the client.

Life-based long-term care benefits

Life insurance policies that provide LTC benefits have been around for some time now. Most are either whole life- or universal life-based and provide immediate leverage in the form of a death benefit that can be accessed for qualifying LTC expenses. At death, any unused benefits pass to heirs income tax-free, and LTC benefits are also typically income tax-free.

If you have clients with old, under-performing cash value policies, a way to cover LTC risk, if suitable for that specific client, is to exchange it for a new life policy with LTC benefits. An added benefit is that there is no out-of-pocket cost to the client to do so. It’s simply repositioning an asset, and obviously, no taxes are paid on any deferred gain with a like-for-like exchange under Section 1035.

There’s another avenue you might not be familiar with: the use of an existing non-qualified annuity to fund a life-based LTC policy. You might be thinking, “Annuities cannot be 1035 exchanged for life insurance,” and you are correct. However, there are products available in the marketplace that can overcome this obstacle. These products link a limited-pay life insurance policy with LTC benefits to a simple deferred annuity. The existing annuity, plus any gain, can be exchanged into the fixed annuity tax-deferred. Then, on an annual basis, a withdrawal is taken from the annuity to fund the limited-pay life policy with LTC benefits. These withdrawals are taxable to the extent of gain in the contract, but they are generally spread over a period of several years to be more palatable for the client.

This approach can have several benefits. First, from an estate standpoint, an asset that starts out as fully taxable to the extent of gain to the heirs at death is slowly turned into a death benefit that is income tax-free. Second, funds available — should a LTC need arise — can be greatly increased by using the cash value of the annuity to establish a life insurance death benefit that is available for qualifying LTC expenses. Lastly, some companies provide the option to purchase extended LTC benefits beyond the death benefit to protect your client(s) against a catastrophic LTC need.