Starting January 1, 2010, there are two important tax changes regarding Long Term Care: 1) distributions from life insurance policies and annuities which have long-term care features are tax-free when used to pay long-term care costs, and 2) both life insurance and annuities can be exchanged tax-free for tax qualified long term care insurance.
If you have an existing annuity contract or life insurance policy and want long-term care insurance, you have several choices. You can either partially or fully exchange the old policy and use the proceeds to purchase a stand-alone long-term care insurance policy. Or you can fully exchange the old policy for a new hybrid insurance or annuity contract that also includes long-term care features so that you will then be able to withdraw money tax-free as long as it is being used to pay for long-term care.
In general, when a financial asset is sold or liquidated, the owner realizes a gain or loss which is subject to income taxation. If you sell you shares of stock in X company and buy shares in Z company, you must recognize a gain or loss on the sale of X company stock. Not so if, instead, your investment was insurance or an annuity. Some assets get special treatment, and insurance is one of them.
Section 1035 of the Internal Revenue Code permits a taxpayer to exchange a life insurance policy for a new life insurance policy or annuity contract, or to exchange an existing annuity contract to another annuity contract without incurring any taxable gains. If there is a gain on the exchange, the gain is carried over to the new policy or contract; and the tax is deferred.
Section 1035 applies to non-qualified annuities and life insurance policies when transferred to a new policy of equal or greater value. A non-qualified annuity is one purchased with after-tax dollars or pursuant to a 1035 exchange. (Moving from one qualified annuity to another is a rollover of qualified funds like an IRA or 403(b) rollover. A 1035 exchange is not needed to defer taxes in that case.)
Why would you want to do an exchange? There are various reasons why you might exchange an old life insurance or annuity policy for a new one. You might be seeking a higher rate of return than what your existing annuity policy offers, you may wish different features to be included in the contract, or you may wish to establish a different type of investment. In the case of life insurance, you may simply wish to transfer the existing cash value to a paid up policy so you can avoid ongoing premium payments.
It is possible to fully surrender the life insurance or annuity contract and purchase a long-tern care product. However, not all companies, or states, offer a single pay Long Term Care Insurance (LTCI) product. The other approach is to make premium payments on the LTCI using a series of partial exchanges. This option is only available for annuities. No partial exchanges of life insurance contracts are permitted.
If you have a life insurance policy that you wish to use to fund LTCI, one alternative may be to exchange the life insurance policy for an annuity, and then do partial exchanges from the annuity to fund long term care insurance premiums. Another alternative may be to exchange the life insurance policy for a linked benefit product, such as a life insurance policy that permits withdrawals for long term care costs.
When using Section 1035, it is of the utmost importance that neither the insured nor the agent transfer the value between the old and new contracts. The old contract (or right to surrender a portion of the contract, for partial exchanges) must be assigned to the new receiving carrier, who then surrenders the contract (or requests partial surrender) to the old carrier using approved forms indicating an intent to perform a 1035 exchange. The old carrier sends the new carrier the cash value directly. If this process is not followed, the tax-free exchange will fail; and a taxable distribution to the contract owner is the result.
Exchanges may not be beneficial for everyone. Before exchanging any policies, make sure your current policy or annuity contract doesn't have a death benefit or other benefit that you don't want to give up. Also, there may be surrender charges for exchanging an existing annuity. Make sure you get competent tax advice before proceeding.