Edward A. Zurndorfer, Certified Financial Planner

Over the last five years, there has been a significant decline in the sale of long term care (LTC) insurance policies. With the exception of the year 2007, sales of LTC insurance policies have decreased each year since 2005.

Insurance experts cite several possible reasons for the sales decline. There is the "use or lose it" aspect of LTC insurance policies. LTC insurance policy owners may pay premiums for years - perhaps decades - and in the event they never incur a need for LTC, they will lose all premiums paid. With most LTC insurance policies, if a policyowner dies before incurring a need for LTC, he or she will lose all of the LTC insurance premiums paid prior to death. There are some LTC insurance policies that offer -- at a significantly higher premium cost -- a "nonforfeiture" option in which all premiums previously by the deceased policyholder will be returned in full to the deceased's family. Some potential purchasers may therefore be disillusioned by the idea of "wasting" the money spent on LTC insurance premiums.

According to LIMRA International, the average annual premium for an individual LTC insurance policy during 2009 was $2,160. Even with some discounts, a married couple may be paying as much as $4,000 to $5,000 per year in order to pay for LTC insurance coverage for both spouses. Many individuals and couples feel that they have alternative ways to protect themselves against a potential financial drain that may occur if they are unable to take care of themselves.

But a recent change to the Internal Revenue Code may make the purchase of LTC insurance more appealing to more individuals. A section of the Pension Protection Act of 2006 (PPA) took effect on Jan. 1, 2010 and includes the following changes:

• Approval of LTC riders on annuity contracts.

Before PPA's passage, LTC riders to pay for LTC-related expenses were permitted in life insurance policies but not in annuity contracts. As a result, LTC riders can now be added to nonqualified (but not to qualified annuities) annuities without losing the tax deferral benefit of annuities.

• Tax-free access to life insurance and annuity cash values to pay LTC expenses.

Until PPA's passage, life insurance or nonqualified annuity cash values could be withdrawn to pay for LTC-related expenses. However, the annuity owner or life insurance policyholder would owe federal and state income taxes on distributions made from the life insurance policy or the pre-taxed earnings of the annuity to pay for LTC expenses. PPA allows these transactions to be considered as nontaxable, provided the distributions are used to pay for qualified LTC expenses.

• LTC insurance policies eligible for tax-deferred exchanges.

Cash value life insurance policies, annuities and LTC insurance policies can be exchanged for LTC insurance policies under the "like-kind" exchange rules of Internal Revenue Code (IRC) Section 1035. PPA now extends this like-kind exchange opportunity to LTC insurance policies.

Individuals who currently own either cash value life insurance policies or nonqualified annuities and who may not qualify for LTC insurance because of health problems may in particular benefit from this tax law change. 

As is always recommended with any new tax law, the "fine print" of PPA should be examined carefully. First, only "qualified" or "tax-qualified" LTC insurance plans are eligible for beneficial tax treatment as described above. That is generally not a problem because 99 percent of all LTC insurance plans sold today contain the product features that allow these policies to be classified as tax-qualified LTC insurance policies.

Annuity contract owners with LTC benefit riders should be aware of the requirement to own a "nonqualified" annuity. As noted, LTC benefits riders may be attached only to nonqualified annuities and not to "tax qualified" annuities. Tax qualified annuities include those annuities held within a retirement plan such as a 401(k) or a traditional IRA. For example, a federal annuitant could not request some or all of a TSP account and purchase a TSP annuity through Metropolitan Life Insurance Company and use tax-free annuity payments to pay for LTC expenses. Taxes would have to be paid first on the TSP annuity payments and then the after-taxed payments could be used to pay for LTC expenses.

Also, there are tax-related issues related to combination LTC products that remain unsettled. In 2009, the IRS issued a public letter ruling (PLR) that may affect some LTC insurance combination designs. The letter ruling was issued as a result of some earlier financial literature that indicated "LTC annuities" are completely tax-free. That may not be true, however, based on what the IRS wrote in PLR 200919011.

PLR 200919011 addresses three questions from an insurance company regarding an annuity attached with a LTC insurance rider. The first question asked whether an annuity with a LTC insurance rider would be considered a "qualified LTC insurance" contract. The IRS responded "yes". The second question was whether annuity distributions - including those distributions containing pre-taxed investment income such as interest and dividends - would qualify as tax-free income if the withdrawals were used to pay legitimate LTC expenses, up to the IRS' maximum daily benefit ($290 per day during 2010). The IRS also responded "yes" to this question.

The third question posed to the IRS was whether the LTC benefits paid out of an investment contract - this includes an annuity or a cash value life insurance policy - would not reduce the "investment in the contract" (also referred to as the annuity owner's or policyholder's "cost basis" in the contract). Some insurance companies have taken the position that in some cases the LTC benefit payouts could reduce the taxability of the annuity's future taxable earnings (dividends, interest) to zero.  If the annuity owner requests a complete annuity payout in order to pay for LTC expenses thereby resulting in a payout of the owner's entire investment in the annuity contract, then any subsequent distribution will be tax-free and the annuity's investment earnings will never be taxed. The IRS said "no" (disagreed).

To illustrate, consider this example: An individual purchases a five percent fixed annuity with a LTC insurance rider. After one year of ownership the annuity is worth $105,000, consisting of the $100,000 initial investment and $5,000 of accrued interest. The annuity owner withdraws from the annuity $5,000 to help pay for some qualifying LTC expenses.  According to PLR200919011, the $5,000 withdrawal comes first out of the "basis". While the annuity contract was initially purchased for $100,000, in the event that owner would sell the contract or withdraw funds from the contract to pay for something other than LTC expenses, the annuity's cost basis remains at $100,000. Also, if the contract is sold or surrendered for more than $100,000, the annuity owner will have to recognize for tax purposes: (1) the excess of the sales price over the cost basis (in this example, the $100,000 original cost); and (2) the amount withdrawn from the annuity to pay LTC expenses will be recognized for tax purposes as ordinary income; in this example, the $5,000 withdrawal will also be recognized as ordinary income. In other words, the both the sales proceeds exceeding the $100,000 cost basis and the $5,000 will be included as income in the year that the contract is sold or surrendered.

Another consideration for LTC combination products is premium cost. If an individual is in need of life insurance or an annuity in addition to LTC insurance, would the individual pay less in premiums for a "combination product" compared to buying a "stand alone" LTC policy plus a separate life insurance policy or an annuity? The answer will depend on how the premium costs compare.

A LTC combination plan consisting of LTC insurance and an annuity may cost as much as 35 to 50 percent less compared to the cost of a "stand alone" LTC insurance policy. The primary reason is that a portion of the LTC insurance coverage and the annuity is in a sense "self-insurance." The LTC coverage may be relatively inexpensive because premium payments for LTC insurance are an acceleration of benefits that would eventually be available to the insured individual or to the insured's beneficiaries as an annuity payout death benefit. Deferred annuities coupled with LTC riders could be less expensive compared to immediate annuities coupled with LTC riders.

Individuals who are interested in purchasing LTC combination insurance and annuity plans are encouraged to contact an experienced and licensed insurance agent who sells these insurance products in their state of residence.  The agent should ideally have full knowledge of both life and LTC insurance products and annuities. Individuals should also discuss with their tax advisors any tax ramifications resulting from buying and owning these combination plans.

How does this new opportunity under PPA affect federal employees and annuitants who may be currently or will be in the future shopping around for an LTC insurance policy?

The federal government offers a group LTC insurance policy to its employees and their relatives - this includes spouses, children 18 and older, parents, step-parents, parents-in-law and step parents-in-law - through the Federal Long Term Care Insurance Program (FLTCIP). Any full or part-time employee is eligible to apply at any time for the FLTCIP. Employees and relatives must each apply and qualify on their own for the FLTCIP and pay the full premium cost with no federal government contribution to the premium cost. As an alternative, individuals can also apply to private insurance companies who offer LTC insurance.

With LTC insurance premiums generally increasing and with no guarantee that the FLTCIP or an insurance company will accept an applicant for LTC insurance, the new tax law offers an alternative to those federal employees and relatives who cannot either afford the LTC insurance premiums or will not qualify for the LTC as a result of a mental or physical condition. Some employees currently with LTC insurance may be seeking ways for paying for possible additional LTC expenses without buying additional LTC insurance. As a result of PPA, employees and their relatives now have additional choices for paying for possible LTC care at an economical, tax-free and hassle-free way.

About the Author

Edward A. Zurndorfer is a Certified Financial Planner, Registered Health Underwriter, Registered Employee Benefits Consultant and Enrolled Agent in Silver Spring, MD and the owner of EZ Accounting and Financial Services, an accounting, tax preparation and financial planning firm also located in Silver Spring, MD.  He is an instructor at federal employee retirement seminars throughout the country for the National Institute of Transition Planning, Inc. and writes numerous columns and books on federal employee benefits.

Posted 07/07/10

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