October, 2006 Newsletter
Provided by Leimberg Information Services
See other issues.
Code Section 7702B Long-term Care Gets New Life - But Will It Be Healthy?
Michael E. Kitces is Director of Financial Planning of the Pinnacle Advisory Group in Columbia, MD and the co-author, with John L. Olsen of the Olsen Financial Group of THE ANNUITY ADVISOR (800 543 0874) , the most comprehensive, practical, and well-balanced book I've seen yet on annuities!
The Pension Protection Act of 2006, signed into on August 17th, 2006 and effective 2010, allows life insurance and annuity companies to offer long-term-care riders on top of regular policies. It also provides that internal charges against the values in annuities and permanent life insurance policies used to pay long-term-care insurance premiums aren't taxed.
Here, Michael fills LISI members in on the details of this legislation involving life insurance, long term care insurance riders, and Section 1035 exchanges. It's yet another surprise in PPA-2006
Section 844 of the Pension Protection Act of 2006 was intended to expand accessibility to tax-favored long-term care insurance by providing the ability for life insurance and annuity contracts to add long-term care insurance riders and use the cash value to cover the cost of long-term care insurance premiums without incurring taxable distributions, effective after 2009. The new law broadens the provisions for Code Section 1035 tax-free exchanges to allow for exchange of life and annuity policies into long-term care insurance contracts.
However, the ordering rules applicable to long-term care insurance premium charges substantially diminish the tax benefits of the new law as a method of acquiring long-term insurance coverage.
Tax Favored LTC Riders Allowed on Life and Annuity Contracts.
Section 844 of the Pension Protection Act of 2006 (PPA 2006), effective after 2009, will allow for life insurance and annuity contracts to carry a long-term care insurance rider on a tax-favored basis. Under the new Code Section 7702B(e)(1), such riders will be treated for tax purposes as a separate contract. This allows the general Code Section 7702B(b) tax-favored treatment of qualified long-term care insurance policies to apply - even though the coverage is actually in the form of a rider on another and different type of policy.
Premium Charges Not Taxable:
Under the new Code Section 72(e)(11), the premium charges associated with the long-term care insurance that are channeled and distributed from the cash value of a life insurance or annuity contract will not be treated as taxable distributions from the insurance or annuity contract (IRC Section 72(e)(11)(B)). However, distributions excluded from income that are used to cover the cost of long-term care insurance will reduce the owner's investment in the contract (but not below zero) when determining gain on future taxable distributions (IRC Section 72(e)(11)(A)).
Insurers Must File Information Returns:
Under the new Code Section 6050U(a), insurance companies will be required to file information reporting returns with the IRS disclosing:
the amount of aggregate charges made against each contract for the calendar year,
the amount of the reduction of the investment in the contract because of these charges, and
the name, address, and TIN of the individual who is the holder of each contract.
Under the new Code Section 7702B(e)(2), any payments for long-term care insurance deducted under a life insurance or annuity contract will be denied an IRC Section 213(a) medical expense deduction for premiums paid.
LTC Riders Not Allowed in Qualified Plans:
Under the new IRC Section 7702B(e)(4), the riders will not be available for qualified annuities purchased under an IRC Section 401(a) employer retirement trust (e.g., 401(k) plan), a 403(a) or 403(b) annuity plan, or an IRA.
Section 1035 Exchanges Expanded:
IRC Section 1035, providing for tax-free exchanges of insurance and annuity contracts, is expanded to allow a life insurance, endowment, or annuity contract to be exchanged for a qualified long-term care insurance policy.
The new IRC Section 1035(a)(4) also allows a qualified long-term care insurance policy to be exchanged for another long-term care policy.
In addition, under the new IRC Sections 1035(b)(2) and (3), an exchange to or from a life insurance or annuity contract that has a long-term care insurance rider to a policy that does not have such a rider will still be treated as like-kind property for exchange purposes.
The new rules of PPA 2006, Section 844, represent a substantial expansion of accessibility for long-term care insurance by providing for new opportunities to pay for long-term care insurance. However, the mechanism that Congress chose to implement the non-taxable use of insurance and annuity cash values substantially diminishes the value of the new provisions.
Nonetheless, the new provisions applicable to 1035 exchanges may still provide substantial new opportunities for purchasing long-term care insurance on a tax-favored basis.
To understand why certain aspects of the new law are not very favorable, though, it is first necessary to fully understand the application of the new rules and what has changed.
Old Rules versus New Rules
Although long-term care insurance riders have existed on life insurance and annuity riders for several years, the tax treatment has generally been significantly less favorable. Life insurance policies have generally provided for coverage by imputing income to the contract holder for long-term care insurance premiums that were deducted from the insurance cash value; annuity contracts, on the other hand, have tended to simply credit any long-term care insurance benefits directly to the annuity cash value, forcing the beneficiary to still take an annuity withdrawal (with the associated ordinary income, gains-first treatment accorded under IRC Section 72(e)(2)(B)) and pay taxes accordingly.
The new rules of PPA 2006 seem to allow for the best of both worlds: tax-free use of cash value to coverage long-term care insurance premiums under the new IRC Section 72(e)(11), and tax-free benefits under the new IRC Section 7702B(e)(1).
BEWARE: Only "QUALIFIED" LTC POLICIES ELIGIBLE.
Only long-term care policies that are "qualified" under IRC Section 7702B(b), as created under the Health Insurance Portability and Accountability Act (HIPAA) of 1996, are eligible for the new rider and 1035 exchange treatment.
The primary difference between qualified and non-qualified long-term care insurance contracts is that the triggers to provide benefits are generally broader under non-qualified contracts, and are not restricted to the Congressionally defined benefit triggers established under IRC Section 7702B(c): that the individual receive care pursuant to a plan of care prescribed by a licensed health care practitioner, and that the individual be certified by a licensed health care practitioner as being "chronically ill" by either being unable to perform at least 2 activities of daily living or requiring substantial supervision due to severe cognitive impairment.
Although most long-term care insurance policies sold today are qualified contracts, some insurers still provide non-qualified contracts.
However, for purposes of the new provisions, all riders to life insurance or annuity contracts must be qualified to receive preferential tax treatment, and 1035 exchanges will only be allowed into qualified long-term care policies.
Limited Benefit for PURCHASING Contracts with Riders
The problem with the new provisions allowing long-term care insurance riders on life insurance and annuity contracts lies in the effect of the new IRC Section 72(e)(11)(A), which states that when charges are deducted from the cash value to cover long-term care insurance premiums, the investment in the contract shall be reduced (but not below zero).
In the world of life insurance and annuities, "investment in the contract" is the tax-equivalent of cost basis. Thus, a withdrawal from the cash value that reduces investment in the contract is essentially the equivalent of withdrawing your cost basis without being forced to withdraw your gains (on which taxes would be due). This cost-basis first treatment can be helpful, but it is not nearly as effective as being allowed to actually use the gains in the contract on a tax-free basis.
For example, imagine an individual who holds a tax-deferred annuity with $100,000 of cash value, and $60,000 of cost basis – the contract has a $40,000 tax-deferred gain. The annuity has a new rider that provides long-term care insurance, and the policy deducts $2,000 from the cash value of the annuity to pay for the coverage. The $2,000 premium charge reduces the cash value to $98,000, but under the ordering rules of 72(e)(11)(A), the investment in the contract is also reduced by $2,000, to $38,000.
Thus, in the end, the individual still has a $60,000 gain (the excess of $98,000 over $38,000) – the only benefit of the rider was the ability to spend the $2,000 long-term care insurance premium out of the annuity's cost basis while allowing the $60,000 gain to remain deferred (since a withdrawal from the annuity, if purchased after August 13th, 1982, would be treated as a gains-first LIFO distribution under IRC Section 72(e)(2)(B)).
Unfortunately, though, the story does not end there. Not only does the charge for long-term care insurance premiums against the cash value of the contract spend down existing cost basis that would have always been tax-free – the new 7702B(e)(2) rules also state that the charges against the contract will not allow a medical expense deduction for long-term care insurance premiums under IRC Section 213(a). Thus, the ordering rules essentially require that the withdrawal be allocated against after-tax dollars that constituted cost basis, but simultaneously disallow a tax deduction for the long-term care insurance premiums spent with those after-tax dollars!
By contrast, if the individual acquiring long-term care insurance were to use any dollars except those under the insurance or annuity contract as a rider, the individual may at least be eligible for a partial or full deduction for the long-term care insurance premiums, subject to the applicable rules under IRC Section 213(d)(10). In the end, using the new long-term care insurance riders may be the best way to ensure paying long-term care insurance premiums only with after-tax dollars, without ever getting a tax deduction, while only continuing to defer a tax gain in the contract that will still be due whenever the contract is surrendered (unless it is a life insurance policy that matures as a tax-free death benefit under IRC Section 101) – that's not exactly an encouraging reason to ever acquire such a contract!
Thus, in Congress's effort to thwart taxpayers from a "double dip" by receiving a tax-free expenditure from an insurance or annuity policy and a tax deduction for the payment at the same time, an individual will usually end out with the worst of both worlds – still retaining all of their pre-tax gains, reducing the cost basis that they could have recovered tax-free, and receiving no tax deduction either!
OPPORTUNITIES FOR RIDERS IN LIMITED CIRCUMSTANCES
Given the issues discussed above, it will be rare that an individual would actually be well-served for tax purposes to purchase a long-term care insurance rider on a life insurance or annuity contract. At best, the expenditure will be a breakeven event – if the long-term care insurance premium were otherwise not going to be deductible anyway, due to the applicable limitations for medical expense deductions, then using the cash value (or rather, the cost basis thereof) of an insurance or annuity policy will leave the individual no better off, but no worse off either.
However, if the contract's cost basis is actually already very close to $0, a long-term care insurance rider may be more useful. This is because, under 72(e)(11)(A), long-term care insurance charges will reduce the investment in the contract, but not below zero. Thus, if the contract has a cost basis so low that the long-term care insurance charges actually would reduce the investment contract to and below zero, then additional long-term care insurance charges will reduce the current value of the contract, without reducing the cost basis (because it's already limited to zero), and will thereby reduce the gain in the contract – yet still not cause a taxable distribution under 72(e)(11)(B). In this case, individuals really will be able to spend down dollars that represent future taxable gains on a tax-free basis for their long-term care insurance coverage.
In addition, it's notable that for some individuals, harvesting the cost basis of their annuity or life insurance policies may still be more advantageous than tapping other sources to cover the cost of coverage. If the individual's only other available sources for cash are illiquid investments, and/or vehicles with even less favorable tax consequences (e.g., pre-tax retirement accounts), it may still be advantageous to acquire coverage with a long-term care insurance rider on an insurance or annuity policy. In such a case, the ability to tap the contract's cost basis without incurring an income tax event by withdrawing the gains may still be a tax-favored strategy, particularly if the existing policy has large gains, relative to the alternatives available for the individual.
In the case of an insurance contract, the individual may be able to tap the cost basis of the insurance, and then hold the contract itself until it matures as a tax-free death benefit, essentially allowing the individual to spend the cost basis and still receive the gains tax-free (although this may still be less favorable than paying with after-tax dollars outside of the contract and receiving a tax deduction for long-term care insurance premiums paid).
It remains to be seen whether insurance companies may offer new long-term care insurance riders that may be added to existing policies, or whether (in all likelihood) individuals will be required to complete a 1035 exchange into a new policy to acquire one with a long-term care insurance rider.
Due Diligence for 1035 Exchanges
Given the delayed effect for the provision of PPA 2006, Section 884, insurance companies will have ample time to establish new insurance and annuity products with long-term care riders. This will provide a strong temptation for many individuals to 1035 exchange on a tax-free basis their existing life insurance or annuity policies to new policies that carry such riders to take advantage of the new rules.
However, beyond the caveats discussed above about the limited tax advantages of this strategy, in evaluating a 1035 exchange due diligence should still be performed on the existing contract as well. The life insurance or annuity policy may provide death benefits, pricing, or other guarantees, in the original contract that are unavailable in the new contract, which may make the overall result less valuable.
It remains to be seen whether or to what extent insurance companies may allow existing insurance or annuity policies to add long-term care insurance riders. Such an opportunity would allow the individual to preserve the existing benefits of the insurance or annuity policy; however, new medical underwriting for the long-term care coverage will likely be required.
New Single-Pay LTC policies
Due to the expansion of the IRC Section 1035(a) rules to allow an exchange of life insurance, endowment, and annuity policies to purchase qualified long-term care insurance, there will likely be new product innovation over the next several years to accommodate the demand for new policies funded with single lump sum payments from existing insurance and annuity contracts. The market for such policies has not been strong in recent years, but the opportunity to use existing policies with substantial cash values will likely reinvigorate this market.
As new products come available, prospective buyers will need to be particularly cautious to understand the provisions of any non-forfeiture benefits applicable to such long-term care policies in the event of untimely death or policy lapse – otherwise, an individual may unwittingly deposit a substantial sum from an existing insurance or annuity contract to a new long-term care contract, and then forfeit some or all of the value with a lapse or death.
Although most single premium long-term care insurance policies provide for some non-forfeiture benefits in the event of untimely death or lapse, additional scrutiny in this area will be warranted when policy exchanges begin after 2009.
Nonetheless, this area represents one of the most favorable tax-planning opportunities under the new Section 884, since these 1035 exchange provisions genuinely provide an opportunity for an individual to utilize the embedded gains in their life insurance or annuity contracts for long-term care insurance, without recognizing the embedded gain.
However, these rules may also necessitate future guidance from the Treasury on the tax consequences of receiving a long-term care insurance non-forfeiture value. In the past, such receipts could never constitute a taxable gain, because the non-forfeiture values would always be less than the aggregate premiums paid.
Under the new rules, though, an individual could exchange a contract with a high cash value and extremely low cost basis into a new long-term care policy, and then surrender the policy to receive the non-forfeiture value, effectively harvesting the cash value from the original policy through the non-forfeiture provisions without paying taxes on the gain. This area will likely be clarified in future Regulations.
The new rules are generally effective for taxable years beginning after December 31, 2009. The Act also restricts the application of the new rules to contracts issued after December 31, 1996. This restriction assures that the contracts that were grandfathered under HIPAA are not affected by the Act.
Overall, the new provisions of PPA 2006, Section 884, should provide a strong boon to the use of long-term care coverage, but the implementation that Congress used will make the provisions allowing 1035 exchanges into single-premium long-term care insurance policies far more advantageous than adding long-term care insurance riders to existing insurance or annuity policies (or 1035 exchanging into insurance or annuity policies with such riders).
With the anticipated extension of long-term care state partnership programs under the Deficit Reduction Act of 2005, signed earlier this year, Congress is clearly seeking to make long-term care insurance coverage an increasingly appealing as a mechanism to fund future long-term health care needs, and as an alternative to spending substantial personal accumulated assets or seeking eligibility for Medicaid.
However, it remains to be seen whether the public will take advantage of the new rules of PPA 2006, Section 884, given the limited tax benefits actually available with respect to long-term care insurance riders!
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
Edited by Steve Leimberg
Steve Leimberg's Employee Benefits and Retirement Planning Newsletter # 386 (September 26, 2006) at http://www.leimbergservices.com Copyright 2006 Leimberg Information Services, Inc. (LISI).
Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Permission.
Section 884 of the Pension Protection Act of 2006; IRC Sections 7702B(b), 7702B(c), 7702(b)(e)(1), 7702B(e)(2), 7702B(e)(4), 72(e)(3), 72(e)(11), 6050U(a), 1035(a), 1035(a)(4), 1035(b)(2), 1035(b)(3), 213(a), 213(d)(10). See also Janet Kidd Steward, "Insurance Changes for Long-Term Care", Chicago Tribune, Sept. 24, 2006.
All NAEPC-affiliated estate planning councils are eligible to receive a discounted subscription rate to the Leimberg LISI service. Please see more information about the offering. You may also contact your local council office / board member to find out whether they are offering the service as a member benefit.