Swapping Life Insurance for Long-Term Care Insurance 

Do you own a life insurance policy that’s no longer essential to your financial goals? You may have purchased a policy long ago, when your children were infants or before their college years. Now that you’re no longer raising a family, your focus has probably changed to your own future needs, which could include some form of long-term care. If you’re exploring tax accounting solutions in Brookfield, it’s worth reviewing how changes to your insurance and long-term care planning may affect your overall financial and tax strategy. An extended nursing home or assisted living facility (ALF) stay could substantially erode — or even wipe out — your life savings.

Possible solution: You may be able to trade in your life insurance policy or, alternatively, an annuity, for a long-term care insurance (LTCI) policy. If certain requirements are met, the exchange is exempt from federal income tax. That could put you in a better position to meet future financial challenges if you need to move into a nursing home or ALF later in life.    

Background Information

The need in this country for some type of long-term care is great. Here are some statistics and estimates from the U.S. Department of Health and Human Services:

• Over half (56%) of Americans turning 65 today will develop a disability serious enough to require long-term services and supports (although many will need assistance for less than three years).
• About one in five of all adults (22%), however, will have a disability for more than five years.
• On average, an American turning 65 today will incur $120,900 in future LTSS costs, measured in today’s dollars.
• Families will pay more than one-third (37%) of the costs themselves out of pocket, with the rest covered by public programs and private insurance. A

When it comes to long-term care costs, be prepared for sticker shock. Meanwhile, the types of LTCI policies, and the resulting costs, can vary. Depending on the policy, it may provide benefits for different types of care, ranging from daily skilled care in an institutional setting to custodial care at home. If you’re considering tax accounting solutions in Brookfield, reviewing the tax implications of long-term care insurance can help you make more informed financial planning decisions. Generally, you qualify for LTCI benefits if a physician certifies that you need assistance in performing one of the usual “activities of daily living.” These activities include bathing, eating, dressing, toileting, walking, and continence.

With some policies, benefits continue until you reach a certain maximum amount. Conversely, the benefits may last for a predetermined number of years. Or the policy may combine the limits and stop paying benefits when either the maximum amount is reached or the cutoff date occurs.      

Consider the Tax Angles

Although you may purchase LTCI coverage outright, you might prefer to exchange a life insurance policy or an annuity for an LTC policy, if you qualify. The tax law generally allows you to make the swap without any adverse tax consequences.

“Wait a minute,” you may say. “Doesn’t a tax law change prohibit these tax-favored exchanges?”

Not exactly. It’s true that a 2017 law eliminated tax-free exchanges of like-kind properties, other than those of real estate, under Section 1031 of the tax code. But exchanges of life insurance policies or annuities for LTCI policies are governed by another tax code section. So the 2017 law doesn’t apply in this case.

The existing rules go back a couple of decades. Under Section 1035, you can exchange one life insurance policy for another, one annuity contract for another, or a life insurance policy for an annuity contract without triggering any taxable gain. (You can’t, however, exchange an annuity contract for a life insurance policy.)

In 2006, Congress added LTCI policies to that list of approved exchanges, effective beginning in 2010. This means you can use an existing life insurance policy or annuity to fund the purchase of a new LTC policy without immediate tax consequences.

As long as you exchange an existing policy or annuity for a stand-alone LTCI policy, you’ll permanently avoid tax on the gain. However, if you exchange it for a policy that combines LTCI benefits with life insurance or annuity benefits, any gains that become part of the new policy’s cash value or annuity payouts may eventually be taxed. In addition, special rules apply to partial exchanges of annuities for LTCI policies, including a 180-day waiting period before making any withdrawals from the annuity.

Here’s an example: Let’s say Nick has a life insurance policy with a $200,000 cash surrender value and a $100,000 tax basis. He exchanges it for a $200,000 single-premium, stand-alone LTCI policy. Before 2010, Nick would have owed tax on the $100,000 gain. But under current law, this is exempt from income tax. If the insurance company didn’t offer single premium policies, Nick could have financed the purchase using a series of partial tax-free exchanges to meet his annual premium obligations.

To execute an exchange, you must arrange a direct transfer of funds from one insurance carrier to the other. If you take possession of the funds — no matter how briefly — you’ll be treated as if you’d made a taxable surrender of the policy or contract. Unlike an IRA, there’s no “rollover” option for tax-free exchanges.

A Word of Caution

Exchanging a life insurance policy or annuity for an LTCI policy isn’t always a simple process. You’ll have to find a financial institution that will accommodate your needs, and you could face underwriting obstacles. If you’re working with tax accounting solutions in Brookfield, they can help you evaluate the financial and tax implications of such exchanges before making a decision. The number of companies that provide LTCI policies — never mind facilitating exchanges — is limited. If you can’t find a suitable match, you may end up acquiring a policy directly instead.

Even so, it’s a good idea to weigh the benefits of obtaining LTCI coverage. We can provide guidance in this area.