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be withdrawn to pay for LTC-related expenses.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