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Tax-Free Exchanges of Annuities for Long-term Care Coverage

It's a rare occasion when I encounter an annuity owner who is unreservedly happy with their purchase.  This isn't to say that a cost-effective annuity doesn't serve a useful purpose given the right set of client circumstances.  Rather, annuity sales practices seem to epitomize the lack of transparency and conflicts of interest that permeate much of the financial advisory industry.  As a result, buyers often seem unaware of the shortcomings of annuities until well after the sale, and annuity salespeople typically get paid the most for selling the worst annuities.

Luckily, even the worst annuities don't have to be "roach motels" - there is often a way out of them without having to sacrifice an arm and a leg.  The best escape route depends on a variety of factors, i.e. the annuity's surrender charge schedule, whether or not it's held in a tax-qualified account, the fine print of the annuity contract, the client's financial situation, etc.

A provision of the Patient Protection and Affordable Care Act (PPACA) offers another possible way out. Distributions from annuities can be taken federal-tax-free if they are used to pay for premiums on long-term care insurance (LTCI) policies.

To be clear, annuity distributions will not receive this tax-free treatment if they are used to pay for long-term care, only for premiums on the insurance.  In fact, these distributions must pass directly from the annuity issuer to the LTCI issuer, without the policyholder taking possession, to be recognized as non-taxable 1035 exchanges.

Furthermore, this strategy only works with non-qualified annuities, i.e. those paid for with after-tax funds and not held in qualified accounts like IRA's and retirement plans.  Also, the ownership of the annuity and long-term care policy must be identical.  An individually owned annuity must be used to fund an individual LTCI policy, and a jointly owned annuity must be used to fund a shared-ownership policy.  And of course, surrender charges may still apply on distributions from the annuity.

So under what type of circumstances is an annuity owner likely to benefit the most from this strategy (assuming there is a desire for long-term care coverage)?  Well, without getting into the gory details of the tax treatment of distributions from non-qualified annuities, this type of exchange will be most advantageous for high-income annuity owners with sizeable gains in their deferred (as opposed to immediate or annuitized) annuities.

But even in this situation, annuity owners must also consider possible tax benefits that might otherwise be available to them if they instead paid for LTCI premiums with other funds.  For example, LTCI premiums might be deductible anyway for some taxpayers who itemize or for the self-employed.

It's certainly not a decision easily analyzed, but it is one that may offer you both an elegant exit from a lousy or unwanted annuity, and a government-subsidized entree into long-term care coverage.

About the Author

Paul Winter, MBA, CFA, CFP® is a Fee-Only financial advisor and fiduciary in Salt Lake City, UT. His independent wealth management firm, Five Seasons Financial Planning, provides professional portfolio management and objective financial planning services to individuals and families, and to their related entities including trusts, estates, charitable organizations, and small businesses.  

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