Let’s suppose you have a boomer client that has recently retired. (Most likely, you have more than one.) Now, let’s say that this client pays premiums on an LTCI policy and has recently purchased an existing immediate annuity contract. They come to you, wanting to know what this means for their tax filing. Are their LTCI premiums deductible as medical expenses? How will they be taxed for the annuity purchase? Luckily, you’ve read this article, and so you know the answer to these and eight other questions your retired clients may ask.
1. Are premiums paid for a qualified long-term care insurance contract deductible as medical expenses?
Amounts paid for any qualified long-term care insurance contract or for qualified long-term care services generally are included in the definition of medical care and, thus, are eligible for income tax deduction, subject to certain limitations. Amounts paid for the medical care of a taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents are deductible subject to the 10 percent adjusted gross income floor. The 10 percent floor is effective for tax years beginning after 2012, but the 7.5 percent floor remains effective for senior citizens aged 65 and older (and their spouses) through 2016.
The deduction for eligible long-term care premiums that are paid during any taxable year for a qualified long-term care insurance contract as defined in IRC Section 7702B(b) is subject to an additional dollar amount limit that increases with the age of the insured individual. In 2014, for persons age forty or less, the limit is $370. For ages forty-one through fifty, the limit is $700. For ages fifty-one through sixty, the limit is $1,400. For ages sixty-one through seventy, the limit is $3,720. For those over age seventy, the limit is $4,660. The age is the individual’s attained age before the close of the taxable year. The limits are indexed annually.
For tax years beginning after 2009, an annuity contract, life insurance policy, or long-term care insurance policy, may be exchanged for a(nother) qualified long-term care insurance contract without taxation.
An amount paid for qualified long-term care services as defined in IRC Section 7702B(c) will not be treated as paid for medical care if a service is provided by an individual’s spouse or a relative unless the service is provided by a licensed professional. A relative generally is any individual who can be considered a dependent under the IRC.
In addition, a service may not be provided by a corporation or partnership that is related to an individual within the meaning of IRC Sections 267(b) or 707(b).
2. Are benefits received under a qualified long-term care insurance contract taxable income?
A qualified long-term care insurance contract is treated as an accident and health insurance contract. Thus, amounts (other than dividends or premium refunds) received under such a contract are treated as amounts received for personal injuries and sickness and are treated as reimbursement for expenses actually incurred for medical care. Since amounts received for personal injuries and sickness are generally not includable in gross income, benefits received under qualified long-term care insurance are generally not taxable.
But there is a limit on the amount of qualified long-term care benefits that may be excluded from income. Generally, if the total periodic payments received under all qualified long-term care insurance contracts (and any periodic payments received as an accelerated death benefit under IRC Section 101(g)) exceed a per diem limitation, the excess must be included in income (without regard to IRC Section 72). If the insured is terminally ill when a payment treated under IRC Section 101(g) is received, the payment is not taken into account for this purpose.
If payments exceed the greater of $330 per day (in 2014; $320 for 2013 and $310 for 2012, adjusted annually for inflation) or the actual amount of qualified long-term care expenses incurred, the excess payment amounts are taxable as income when benefits are paid. Notably, this “per diem” rule will not apply, regardless of payment size, if the payments are fully allocable to the reimbursement of the insured’s long-term care insurance expenses. However, payments in excess of reimbursements may become taxable to the extent they exceed the per diem limitation as calculated above.
3. How is the purchaser of an existing immediate annuity contract taxed?
If the purchaser receives lifetime proceeds under the contract, the purchaser is taxed in the same way as an original owner would be taxed, but with the following differences. The purchaser’s cost basis is the consideration the purchaser paid for the contract, plus any premiums the purchaser paid after the purchase and less any excludable dividends and unrepaid excludable loans received by the purchaser after the purchase.
If the contract is purchased after payments commence under a life income or installment option, a new exclusion ratio must be determined, based on the purchaser’s cost and expected return computed as of the purchaser’s annuity starting date. The purchaser’s annuity starting date is the beginning of the first period for which the purchaser receives an annuity payment under the contract.
4. What is the tax treatment for an annuity with a long-term care rider?
Under the Pension Protection Act, annuities issued after December 31, 2009 may include a qualified long-term care insurance rider. Under these rules, inclusion of the rider will not trigger taxable distributions as premiums are deducted from cash value for long-term care premiums, although such charges will reduce investment in the contract. In addition, all long-term care benefits paid under the rider will be tax-free and are excludable from the recipient’s gross income (and not reduce investment in the contract).
In a private letter ruling, the IRS analyzed the federal income tax treatment of a particular company’s long-term care insurance rider to be offered with certain annuity contracts by an insurance company with respect to taxable years beginning after December 31, 2009, and ruled that the rider will constitute a qualified long-term care insurance contract.
5. Is the full gain on a deferred annuity or retirement income contract taxable in the year the contract matures?
If the contract provides for automatic settlement under an annuity option, the lump sum proceeds are not constructively received in the year of maturity. The annuity payments (whether life income or installment) are taxed under the regular annuity rules. In computing the exclusion ratio for the payments, the amount to be used as the investment in the contract is premium cost, not the maturity value.
Of course, if the contract owner takes a one sum settlement at maturity, he or she must include the gain in gross income for the year in which he or she receives the payment.
6. Who qualifies for the tax credit for the elderly and the permanently and totally disabled and how is the credit computed?
The credit is available to taxpayers age 65 or older, or those who are under age 65, retired on disability, and were considered permanently and totally disabled when they retired.
“An individual is permanently and totally disabled if he is unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or which has lasted or can be expected to last for a continuous period of not less than 12 months. An individual shall not be considered to be permanently and totally disabled unless he furnishes proof of the existence thereof in such form and manner, and at such times, as the Secretary may require.”
The credit equals 15% of an individual’s IRC Section 22 amount for the taxable year, but may not exceed the amount of tax. This IRC Section 22 base amount is $5,000 for a single taxpayer or married taxpayers filing jointly if only one spouse qualifies for the credit; $7,500 for married taxpayers filing jointly if both qualify; and $3,750 for a married taxpayer filing separately. Married taxpayers must file a joint return to claim the credit, unless they lived apart for the entire taxable year.
This base figure is limited for individuals under age 65 to the amount of the disability income (taxable amount an individual receives under an employer plan as wages or payments in lieu of wages for the period he is absent from work on account of permanent and total disability) received during the taxable year. (Proof of continuing permanent and total disability may be required.) For married taxpayers who are both qualified and who file jointly, the base figure cannot exceed the total of both spouses’ disability income if both are under age 65 or if only one is under age 65, the sum of $5,000 plus the disability income of the spouse who is under 65.
The base figure (or the amount of disability income in the case of individuals under age 65, if lower) is reduced dollar-for-dollar by one-half of adjusted gross income in excess of $7,500 (single taxpayers), $10,000 (joint return), or $5,000 (married filing separately). A reduction is also made for Social Security and railroad retirement benefits that are excluded from gross income, and certain other tax-exempt income.
7. Are contributions to, and postretirement payments from, a deferred compensation account balance or nonaccount balance plan subject to FICA and FUTA taxes?
There are two timing rules for the treatment of deferred compensation amounts under the Federal Insurance Contributions Act (“FICA”) and the Federal Unemployment Tax Act (“FUTA”): (1) the “general timing rule,” and (2) the “special timing rule.”
The general timing rule provides that amounts taxable as wages generally are taxed when paid or “constructively received.”
The special timing rule applies to amounts deferred by an employee under any deferred compensation plan of an employer covered by FICA. The special timing rule applies to voluntary salary, commission and bonus reduction plans, employer-paid supplemental plans, funded and unfunded plans, private plans, and eligible or ineligible Section 457 plans. It does not apply to excess (golden) parachute payments.
Section 409A has not changed the application or calculation of employment taxes. Under these rules, vested nonqualified plan contributions (and the earnings on them) generally are taxable for employment tax purposes (compared with income tax purposes) when they are contributed (as in the case of most voluntary salary/bonus deferral plans) or when they are vested (as in the case of an employer-paid supplemental plan with risks of forfeiture on the benefits).
General Timing Rule