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4 Tax-Efficient Ways to Pay Long-Term Care Insurance Premiums

The costs of healthcare and long-term care (LTC) are top of mind today. Fortunately, the tax code offers incentives to encourage the purchase of long-term care coverage.

Here are 4 ways clients can lessen the cost burden of paying long-term care premiums.

1. Make tax-free withdrawals from a Health Savings Account (HSA).

Tax-free withdrawals from an HSA can be used to fund a portion of premiums on a qualified LTC policy. The funds can offset premiums on a traditional LTC insurance policy, or a hybrid life or annuity policy that includes LTC benefits such as an LTC rider. An HSA account can also be used toward premiums on a policy with LTC benefits for a spouse. The allowable withdrawal from an HSA to cover these premiums is limited to the age-based rules below, which change annually for inflation:

Attained Age Before Close of Taxable Year 2018 Limits
40 or less $420
41-50 $780
51-60 $1,560
61-70 $4,160
71+ $5,200

For more information on HSA accounts, please see blog article 3 Risk Management Solutions: Going “Long” on Longevity.

2. Deduct long-term care premiums as a medical expense.

Premiums on qualified LTC coverage can be deducted as a medical expense on the individual tax return. That is, if a taxpayer has medical expenses that exceed 7.5% of annual adjusted gross income (AGI), premium paid on a qualified policy that covers long-term care costs can be itemized as a medical expense deduction, subject to the same age-based limits in the above chart.

However, clients cannot double dip. That is, if tax-free dollars of an HSA are used to fund premiums for qualified long-term care coverage, the premium cannot be deducted as a medical expense as well.  Note that the 7.5% threshold will change to 10% of AGI with the 2019 tax return, as per the 2017 Tax Act. Individuals age 65 and older, though, are not subject to the 10% of AGI change and can continue to benefit from the 7.5% threshold.

3. Tax-Free 1035 Exchange of Annuity.

Clients can exercise a 1035 tax-free exchange of an annuity contract for a traditional LTC policy, or for a new annuity contract that includes LTC benefits. A 1035 exchange allows certain like-kind property to be exchanged without triggering taxation on any gain in the contract.

Because of the tax-free nature of long-term care insurance, the 1035 exchange effectively ensures that any taxable gain on the annuity disappears entirely.

Instead of exchanging the entire annuity, it may be possible (if the insurer allows) to do a systematic partial 1035 exchange to pay the annual long-term care insurance premium. In this way, the client benefits from a more tax efficient way of funding LTC coverage.

CAVEAT: To receive the tax-deferred treatment on the exchange, all the standard requirements of the 1035 exchange must be met. The amounts must be assigned directly from the old life insurance or annuity policy directly to the new long-term care insurance company issuing the policy. If the funds are distributed to the policy owner, they are deemed by the IRS as irrevocably distributed and the normal taxation rules apply. To obtain the favorable tax treatment of a 1035 exchange, the company issuing the new long-term care insurance policy must be willing and able to obtain the funds directly from the prior life insurance or annuity company in accordance with the rules of a proper 1035 exchange

4. Tax-free 1035 Exchange of a Life Insurance Policy.

A 1035 tax-free exchange is also available for clients who want to switch out an existing life insurance policy to an LTC policy, or to a new life insurance policy that includes an LTC or chronic illness rider. This option can be useful for clients age 55-65 whose needs have changed and who are now focused on their potential need for long-term care.

The below chart generally summarizes the IRC Section 1035 exchange rules

1035 EXCHANGE1 RULES WHEN CONSIDERING OPTIONS FOR TAX-QUALIFED2 LONG-TERM CARE COVERAGE3
FROM: TO: PERMISSIBLE?
YES/NO
Traditional LTC Insurance Policy New Traditional LTC Insurance Policy YES
Existing Life Insurance Policy New Life Insurance Policy YES
Existing Life Insurance Policy New Life Insurance Policy with LTC Rider, or to make systematic partial 1035 exchanges to pay premiums on a new LTC Policy YES
Existing Life Insurance Policy New Annuity Policy with or without LTC Rider YES
Annuity Contract Traditional LTC Insurance Policy, or to make systematic partial 1035 exchanges to pay premiums on a new LTC Policy YES
Annuity Contract New Annuity Contract with LTC Rider YES
Annuity Contract New Life Insurance Policy, with or without LTC rider NO

Footnotes:

1 Internal Revenue Code Section 1035(a), as established by Section 844(b) of the Pension Protection Act (PPA 2006), governs the rules for permissible tax-free exchanges. NOT all long-term care insurance companies accept 1035 exchanges or are set up to do them.  Although a 1035 exchange will allow the exchange of contracts to be tax-free, insurance contract surrender charges may still apply when the exchange is executed.

2 A “tax qualified”LTC policy is defined under IRC Section 7702B. The annuity policy must be a “non-qualified” annuity, defined as annuities purchased with after-tax funds (as opposed to IRAs or retirement annuities that are purchased with pre-tax dollars).

3Annual LTC rider charge is not included in annual taxable income. However, cost basis in the contract is reduced annually by the amount of the rider charge. See PPA 2006, changes effective after Dec.31, 2009.

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