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Section 1035 alternatives for long-term care protection

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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. 

Annuity-based long-term care benefits

Annuity-based LTC approaches are newer on the scene, but they have benefitted greatly from legislation enacted over the past few years. These products provide accumulation for future LTC expenses rather than a death benefit, with unused cash value passing to heirs at death. In addition, they also typically offer either an optional or built-in extension of benefits that will continue LTC benefits after the annuity’s cash value has been exhausted by LTC expenses.

The appeal of annuity-based LTC approaches greatly increased with the advent of the Pension Protection Act — allowing withdrawals from these annuities to be income tax-free for qualifying LTC expenses. Note, though, that only specific annuities that meet strict federally tax-qualified long-term care insurance parameters are eligible for this tax treatment. Meaning, if your client currently owns a non qualified annuity, he or she will need to exchange it for an eligible annuity with qualified LTC benefits to take advantage of this opportunity.

Exchanging an existing annuity for another with LTC benefits can certainly be attractive if suitable for the client. A recent IRS clarification (Notice 2011-68) even allows for a portion of the incoming 1035 exchange to fund not only the annuity, but also the extension of benefits option — if it requires a separate premium. The portion directed to the extension of benefits is not subject to federal income taxes; rather, it is treated as a reduction of cost basis. 

Traditional long-term care insurance

The Pension Protection Act created a new market with updated tax treatment for annuities with LTC benefits, but it also changed Section 1035 rules to allow traditional annuity and life insurance policies to be exchanged for new, stand-alone LTCI policies. The law mandates that this exchange must be for a federally tax-qualified policy, but most LTCI products available today meet that definition.

Not all companies honor this type of 1035 exchange yet, but the number is growing. A best practice is to check with the companies of both the existing and new policies and research their guidelines. In addition, the exchange does not necessarily need to be for the full value of the existing policy. A partial 1035 exchange could be executed, for example, on an annual basis to pay ongoing premiums.

The appeal of funding an LTCI policy in this manner is that tax-deferred gain could be used to pay LTCI premiums free from federal income tax. A downside is that there is no cash value within a traditional LTCI policy, meaning there is only a benefit if LTC is needed. 

Plenty of options

Never miss an opportunity to discuss long-term care planning with your pre- and post-retiree clients. The important thing to know is that there are more options than ever to help you meet the needs, wants and desires of almost any client.

While Section 1035 exchanges do not make sense in all situations and the protection and coverage provided by the current contract should be carefully weighed and considered, you and I know that clients’ situations do change. There will be situations where the customer’s cash value might be better used in a product that provides LTCI protection. With a little creativity, we can make a dent in the coverage gap before the next LIMRA survey of Americans ill-prepared for the significant costs associated with end-of-life care.

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This material is designed to provide accurate and authoritative information with regards to the subject matter covered and is not rendering legal, accounting or tax advice.