For 99 percent of estate-planning clients, estate taxes are no longer the greatest financial threat to passing wealth onto the next generation. This peril has been usurped by the possibility of ruinously expensive long-term care (LTC) costs. But, many clients perceive premium payments for LTC insurance, which would undoubtedly pay for these costs, as only slightly less ruinous, especially if the client waits until retirement to purchase coverage. Sadly, many retirees feel compelled to choose between divesting themselves of their assets to qualify for public benefits or rolling the dice, hoping to escape an expensive LTC stay.
Fortunately, a series of legislative changes and favorable guidance from the Internal Revenue Service, approving partial tax-free exchanges from both life insurance and annuity contracts for LTC policies, provide a new, less painful source for LTC premiums. Moreover, these new rules will permit taxpayers to avoid ever paying federal income tax on accumulated annuity income or taxable gains within life insurance policies, if the taxpayers use the funds to purchase LTC coverage.
In short, the new partial tax-free exchange rules allow taxpayers to access cash values from existing life insurance and annuity contracts to pay for LTC coverage on a tax-free basis. In many cases, life insurance policies that are both rich in cash value and no longer protect against the financial loss of a premature death can be redirected, tax-free, to address the real threat to the taxpayer’s financial security: LTC needs. By allowing taxpayers to redirect the cash value from existing life insurance and annuity contracts, these partial tax-free exchange rules may finally make much-needed LTC coverage more affordable.
Total Tax-free Exchanges
The tax-free exchange of an entire life insurance or annuity contract for another (as opposed to a partial tax-free exchange) has been a familiar part of the tax-planning landscape for many years. The provisions of Internal Revenue Code Section 1035 permit the tax-free exchange of a life insurance policy for another, an annuity contract for another, as well as the exchange of a life insurance policy for an annuity contract. Yet, the exchange of an annuity contract for a life insurance policy goes beyond the purview of Section 1035 and isn’t permitted, presumably because such an exchange would allow a taxpayer to convert taxable annuity income into a potentially income tax-free life insurance death benefit. Significantly, the Pension Protection Act of 2006 added LTC insurance policies to the familiar tax-free exchange hierarchy,1 creating a panoply of tax-free exchanges for taxpayers to employ. (See “Potential Insurance Tax-free Exchanges,” p. 45.)
Partial Tax-free Exchanges
The partial tax-free exchange of a life insurance or annuity contract (as opposed to a total tax-free exchange of an entire contract) is a newer, more controversial phenomenon in federal tax law, seemingly because its origin is judicial rather than statutory. In 1998, the Tax Court in Conway v. Commissioner2 held that a partial tax-free exchange involving a non-qualified (non-individual retirement account) deferred annuity met the requirements of a tax-free exchange under Section 1035. By grudgingly acquiescing,3 the IRS gave clear notice that it intended to scrutinize partial tax-free exchanges and disqualify those that attempted to avoid the annuity income tax rules, which require a taxpayer to first recognize taxable income on a distribution from an annuity before the taxpayer’s return of his cost basis (the income-first rule). The IRS feared that taxpayers would partially exchange a portion of a highly appreciated annuity (that is, an annuity with a value that significantly exceeds its basis) for a second smaller annuity, then subsequently surrender it. Because a pro rata portion of a taxpayer’s basis and taxable gain in a given contract each transfers pro rata to the second contract in a tax-free exchange,4 the subsequent surrender of the smaller annuity received in the exchange would result in a smaller portion of taxable income. In essence, by surrendering the smaller annuity received in a tax-free exchange, a taxpayer can effectively avoid the income-first5 rule to the extent of his basis transferred to the smaller annuity.
Example: Suppose a taxpayer invests $50,000 in an annuity that now has a value of $100,000 due to income earned by the annuity. The taxpayer wishes to take a lump-sum distribution of $50,000. Under the income- first rule, the distribution will be taxable until all of the income earned inside the annuity is exhausted. Thus, the entire $50,000 withdrawal is taxable. If, however, the taxpayer does a partial tax-free exchange of $50,000 from the original annuity to a second annuity, the second annuity will have the same ratio of taxable gain to basis as the original annuity ($25,000 of basis and $25,000 of gain). So, if the taxpayer withdraws the same $50,000 from the second annuity, only the first $25,000 of the distribution will be taxable, because the remaining $25,000 will be a tax-free return of basis. Thus, by dividing the amount of taxable income in the original annuity into two smaller annuities through a partial tax-free exchange, then surrendering one of them, the taxpayer has effectively reduced his taxable income from $50,000 to $25,000 on the exact same distribution. (See “Surrender Smaller Annuity,” p. 46.)
Accordingly, when the Tax Court in Conway cleared the way for partial tax-free exchanges of annuities, the IRS felt compelled to discourage taxpayers from manipulating the income-first rule, as illustrated above, evidenced by a series of IRS notices and revenue procedures. The IRS’ first effort to direct post-Conway partial tax-free exchange traffic was Notice 2003-51,6 which held that a withdrawal from either annuity involved in a partial tax-free exchange within two years of the date of the exchange caused both annuities to be treated as aggregated. This result essentially disregarded the tax-free exchange in its entirety by treating the amount distributed to the taxpayer as income to the extent of the gain in the original annuity. But, if the taxpayer qualified for certain exemptions under IRC Section 72(q) (which imposes a 10 percent penalty on premature distributions from annuities), the IRS would respect the partial tax-free exchange. These Section 72(q) penalty exemptions include, for example, having a disability or attaining age 591/2.7 Notice 2003-51 intended to offer some relief from the two-year distribution embargo period, but to prevent the taxpayer from manipulating the Section 72(q) penalty exemptions to avoid the income-first rule. The next turn of the screw occurred in 2008, when the IRS published Revenue Procedure 2008-24,8 which superseded Notice 2003-51 by reducing the two-year distribution embargo period to one year.
The most recent chapter in the partial tax-free annuity exchange saga occurred in 2011, when Rev. Proc. 2011-389 superseded the guidance provided by Rev. Proc. 2008-24. Significantly, the distribution embargo period for post-exchange distributions was further reduced to 180 days. Additionally, Rev. Proc. 2011-38 abandoned the Section 72(q) penalty exemption regime as a source of permitted distributions. Instead, if a distribution occurs during the 180 days following the date of the exchange, the IRS will consider all of the facts and circumstances surrounding the exchange, apply general tax principles and focus on the substance of the transaction. While hardly a bright line test, no doubt the IRS continues to narrow its focus on exchanges and distributions or surrenders entered into solely for tax avoidance purposes.
Yet, the IRS’ grasp under Rev. Proc. 2011-38 still extends for only 180 days after the date of the exchange. Moreover, IRS scrutiny, such as it is, occurs only on an audit of individual income tax returns, probably for a reason other than a partial tax-free annuity exchange. Interestingly, all of the annuity game playing that the IRS sought to prevent in its prior notices and revenue procedures is now blessed, as long as the taxpayer can delay distributions for at least 180 days. These new rules apply to partial tax-free exchanges of an annuity contract that occur on or after Oct. 24, 2011.
But, the ability to manipulate the annuity income tax system is hardly the most significant consequence of the evolution of the partial tax-free exchange rules, especially when the liberalized, partial tax-free exchange provisions are combined with the addition of LTC insurance policies to the tax-free exchange hierarchy of Section 1035. There’s a unique synergy between LTC insurance policies and the partial tax-free exchange rules, but to appreciate their usefulness, one should have a basic understanding of the variety of trees in the LTC forest.
Types of LTC Policies
The first and most basic type of type of LTC insurance policy is a standalone policy that pays a maximum benefit per diem once the insured is eligible to claim benefits. The contract has no cash surrender value and pays no death benefit, except for a return of premium if the insured selects and pays for that feature. This standalone policy can be either a “lifetime pay” contract, in which the insured typically pays level premiums for the life of the contract or until the insured first becomes eligible to claim benefits, or a “limited pay” contract, in which the insured has the option to pay premiums in full within a 10-year period or before the insured attains age 65 (or some other retirement age). Hence, the salient features of the standalone LTC-only policy include periodic, equal premium payments (as opposed to a single premium payment), no benefits during the insured’s lifetime other than the payment of LTC expenses10 and no death benefit other than, perhaps, the return of the premium feature, if purchased.
The next generation of LTC insurance policies, authorized by tax law after Dec. 31, 1996,11 consists of policies that combine LTC benefits with life insurance or annuity benefits. Thus, an insured can purchase a life insurance policy that not only pays LTC benefits during the insured’s lifetime, but also pays a life insurance death benefit at the insured’s death. Similarly, an individual can purchase an annuity that will pay LTC benefits, which are excludible from income,12 or pay annuity benefits for normal retirement income needs, which are taxable under the income first rule. Typically, the payment of LTC expenses will reduce (and potentially eliminate altogether) either the death claim benefit or retirement annuity benefit, depending on which combination product the insured purchases. The insured can pay premiums on such combination products either in periodic amounts over time or in a lump sum. These life insurance/LTC and annuity/LTC products, referred to as “combo policies,” often appeal to people who don’t wish to lose the consideration paid for LTC coverage if they never make a claim during their lifetime. The premiums on combo policies are typically larger than premiums on standalone LTC-only policies because the insured essentially purchases two benefits, each having an actuarial cost. Whether a combo policy performs better than a separately priced standalone, LTC-only policy combined with a separately priced life insurance or annuity contract is a subject for lively debate, which is beyond the scope of this article. (See “Types of Long-term Care Policies,” p. 48.)
What’s clear, however, is that the LTC insurance policy must be able to digest the tax-free exchange funds that the insured directs to it. While a combo policy can absorb a large infusion of cash that would flow from the tax-free exchange of an entire policy, a standalone LTC-only policy with an annual premium requirement can’t, since such policies typically have no ability to accept prepayment of premiums. Thus, when the choice of policy dictates the payment of equal periodic premiums over time, a partial tax-free exchange from a life insurance or annuity contract is an exact fit. Indeed, absent the authority to do partial tax-free exchanges, the ability to do full tax-free exchanges would be of little or no use in funding commonly purchased standalone LTC-only policies with only an annual premium requirement.
Using Taxable Gain
Similar to the income-first rule regarding taxation of non-annuitized distributions from annuities, lifetime distributions or withdrawals from life insurance policies (other than policy loans), as well as complete policy surrenders, are taxable to the extent the distributions exceed the insured’s cost basis (the basis-first rule). While the taxable gain of a life insurance policy can escape taxation when the designated beneficiary claims the death benefit, annuity proceeds will always be taxable to someone at some time. On the other hand, the payment of a portion of LTC premiums may be tax deductible as a medical expense,13 although medical expense deductions provide a tax benefit only to the extent the amount of such deductions exceeds 7.5 percent of the insured’s adjusted gross income (increased to 10 percent after 2012),14 which it seldom does. But what if non-deductible LTC premiums could be paid with otherwise taxable income in a manner that escapes recognition of the income? This, of course, is exactly what’s accomplished when a gain-laden life insurance or annuity contract is exchanged tax-free, partially or totally, for an LTC product.
Interestingly, recall that the gain and basis in the original contract are transferred pro rata to the new contract in the exchange.15 Thus, with each partial exchange, a portion of the gain is transferred to the LTC policy, reproducing a vertical slice of the original contract’s ratio of gain to basis in the new policy. In a standalone LTC-only policy, the annual premium is completely absorbed by the policy upon receipt. A partial tax-free exchange for a combo policy, however, creates an internal fund of cash value (consisting pro rata of basis and gain), which in turn is used to pay premiums on the LTC rider on the life insurance or annuity contract. As a result of these premium payments, the life insurance policy’s cash value or the annuity balance decreases. In contrast to the partial tax-free exchange and its pro rata vertical slice of gain and basis, the payment of these internal LTC premiums are paid first from the combo policy’s basis, then from gain; essentially a horizontal slice of the original contract’s ratio of basis to gain, with the first slice being basis and the later slice being gain. The ratio of basis to gain in a combo policy is important because it will govern the taxation of any distributions from the combo policy for general retirement needs that aren’t excludible from income as LTC benefits. In all cases, however, whether in a standalone LTC-only policy or a combo policy, to the extent that gain is used to pay LTC premiums, the gain has permanently escaped tax.
Best Policies to Exchange
Selecting a policy for a partial tax-free exchange to pay for LTC premiums involves more than merely the tax law. First, the life insurance company issuing the original policy must permit a partial exchange. This is partly driven by what the company’s computers are programmed to calculate when an exchange occurs. Companies aren’t anxious to make it easy to lose policy values to another company. There’s also the effect that a partial tax-free exchange has on the original policy, which loses value in the exchange. While the effect may be minimal with respect to annuity contracts, the loss of value in a life insurance policy may threaten the long-term viability of the coverage. Accordingly, the client wishing to do a tax-free exchange, especially a partial exchange, must have one eye on the tax law and the other eye on the policy that’s losing value. Which then, are the best policies for such exchanges?
Nonqualified annuities. A partial tax-free exchange of a nonqualified annuity would ordinarily be the first choice to pay LTC expenses. Again, a pro rata portion of the gain and basis transfers from the original contract, and insurance company computers can easily account for the transfer. The surviving original annuity contract is in no way imperiled; it just has less funds. But, the insured must take care to keep partial tax-free exchanges within the limits circumscribed by contractual surrender penalties. Most contracts, for example, permit a 10 percent penalty-free withdrawal each year. Before doing a partial tax-free exchange, the insured should also consider the effect, if any, the withdrawal would have on any contractual annuity guarantees provided by the contract, such as a guaranteed death benefit that’s higher than the current annuity value of the contract or guaranteed withdrawal benefits.
Universal life policies. Universal life policies, characterized by flexible premiums, act much like a checkbook and may also be a good choice for partial tax-free exchanges. Like a checkbook, premium payments and earnings are deposits, and expense and mortality charges are checks written from the account. A partial tax-free exchange to pay LTC premiums is just another check written from the policy’s cash account. Again, a pro rata portion of the gain and basis in the original policy is transferred to pay LTC premiums. But, unless the exchanged funds are replenished, or unless the amount of the death benefit is reduced, partial tax-free exchanges may hasten the lapse of the policy. Yet, if a policy is underfunded, and the insured doesn’t wish to continue making premiums payments, reducing the death benefit to reduce mortality changes and then subsequently exchanging the policy (along with any taxable gain) for an LTC policy, either partially over time or completely all at once, can be a winning strategy.
Several mutual insurance companies that issue traditional (non-universal life) insurance policies pay dividends, which the insured can use to purchase additional insurance (known as “paid-up additions”). These additions can be a source of value for partial tax-free exchanges to pay LTC premiums. While the death benefit of the original policy will decrease, exchanging the value shouldn’t present any risk of the policy lapsing. Harvesting paid-up additions to pay periodic LTC premiums may be an excellent way to pay premiums without affecting the insured’s day-to-day cash flow.
No Paid-up Additions
Some insurance companies that issue traditional life insurance with a fixed annual premium, won’t permit a partial tax-free exchange from the policy. First, the exchange may threaten the viability of the policy, and second, accounting for the disruption to the interrelated parts of the policy may be too costly. Such policies could, however, be a candidate for a complete tax-free exchange for combo policies, which would absorb the entire cash value. If the insured wished to use the value from a traditional life insurance policy to pay the annual premiums of a standalone LTC-only policy, the life insurance policy could first be exchanged for an annuity, then partial tax-free exchanges could subsequently be made from the second annuity to pay the periodic LTC premiums. This strategy would have to take into account the surrender penalties of the annuity received in the exchange. Alternatively, the exchanges could be made for an annuity sponsored by a no-load mutual fund in which the annuity is often not subject to surrender charges.
Worth the Premiums?
At the end of the day, no one wants to pay LTC insurance premiums. A paid-up LTC insurance policy with lifetime benefits, even if purchased tax-free by partial exchanges, provides considerably less pleasure than a trip to Tuscany or a Caribbean resort. But, the only thing worse than paying premiums is not having the insurance when you need it. On the subject of long life and its many challenges, Mark Twain advises, “If you can’t make 90 by a comfortable road, don’t go!”16 This is true, but the timing is tricky. For those unable or unwilling to follow Twain’s advice, there’s LTC insurance; and now there are tax-free exchanges to help pay for it.
1. Pension Protection Act of 2006 P.L. 109-280, Section 844.
2. Conway v. Commissioner, 111 T.C. No. 350 (1998).
3. Action on Decision, 1999-016 (Nov. 26, 1999).
4. Revenue Ruling 2003-76, 2003-2 C.B. 355.
5. Internal Revenue Code Section 72(e)(2).
6. Internal Revenue Service Notice 2003-51, 2003-2 C.B. 361.
7. The IRC Section 72(q) exemptions permitted by the 2003 notice (supra, note 4) included all of the events described in Section 72(q)(2), as well as similar life events, such as divorce or loss of employment, so long as they weren’t contemplated at the time of the partial exchange.
8. Revenue Procedure 2008-24, 2008-1 C.B. 684.
9. Rev. Proc. 2011-38, 2011-30 I.R.B. (June 28, 2011).
10. Standalone long-term care (LTC) contracts that are qualified under IRC Section 7702B are prohibited from having a cash surrender value that can be assessed by the policyholder during the life of the contract or upon its surrender.
11. Supra, note 1.
12. IRC Sections 7702B(a)(2) and 104(a)3.
13. IRC Section 213(d)(1) allows a portion of any LTC premium paid to be treated as a deductible medical expense, but the amount of premium that’s eligible to be deducted depends on the age of the insured. For 2012, the amounts that may be deducted are:
Age 40 or less – $350
41 to 50 – $660
51 to 60 – $1,310
61 to 70 – $3,500
71 or more – $4,370
14. IRC Section 213(a).
15. Supra, note 4.
16. Mark Twain made these remarks about longevity at his 70th birthday party. I’ve paraphrased and updated them to reflect increases in longevity. For his original remarks, see “Celebrate Mark Twain’s Seventieth Birthday,” New York Times, Dec. 6, 1905.