Pension Protection Act: How To Use An Annuity To Pay for Long-Term Care Expenses
This article is co-authored by Gil Edwards, RICP® and Nick Gearhart, CFP®.
An aging population with escalating long-term care costs share a common concern : “How am I going to pay for my future health expenses?” Many are looking at their investment portfolio and wondering how to use it to pay for care tax-efficiently.
Consider one option for long-term care—annuities. Distributions from non-qualified annuities accumulate wealth on a tax-deferred basis. However, distributions from these annuities are generally taxable—a significant deterrent to using these funds for long-term care expenses. An option to use for healthcare? Yes. A tax-efficient option? No.
The Pension Protection Act of 2006 introduced significant changes to the tax treatment of annuities with long-term care benefits. It allows certain annuity contracts to include long-term care insurance features that are treated similarly to standalone long-term care insurance contracts.
What is the Pension Protection Act (PPA) of 2006?
The Pension Protection Act (PPA) of 2006 is a US federal law enacted to strengthen private pension plans and enhance retirement savings. It introduced new funding requirements for defined benefit pension plans, encouraged employers to adopt automatic enrollment features in 401(k) plans, and allowed for Roth 401(k) accounts.
How does the Pension Protection Act (PPA) impact long-term care expenses?
PPA allows you to exchange a non-qualified annuity with a long-term care insurance policy. It relies on two sections of the Internal Revenue Code: 1035 Exchange and Section 7702B(e).
- A 1035 exchange allows a tax-free transfer of cash values or policies between insurance or annuity contracts.
- Section 7702(B)e outlines the rules and guidelines for defining life insurance contracts and how they qualify for favorable tax treatment.
In short, 1035 exchanges allow the transfer; 7702(B)e defines which contracts qualify.
Here’s the step-by-step roadmap of implementation:
- Section 1035 Exchange: The first step is to perform a 1035 exchange from the existing non-qualified annuity to a new one compliant with the Pension Protection Act. This exchange is tax-free, meaning the accumulated earnings in the original annuity will continue to grow tax-deferred in the new one.
- Long-Term Care Rider: The new PPA-compliant annuity must include a long-term care rider. This rider allows the annuity owner to tap into the annuity’s death benefit to pay for long-term care expenses, tax-free, as per the PPA.
- Qualifying for Benefits: The annuity owner must be certified as chronically ill by a licensed health care practitioner, meaning they cannot perform at least two activities of daily living (ADLs) for at least 90 days or require substantial supervision due to cognitive impairment.
- Claiming Benefits: If the annuity owner meets these requirements, they can access their annuity’s death benefit for long-term care expenses. These distributions are tax-free per Section 7702B(e) of the IRC.
Benefits of integrating non-qualified annuities with long-term care insurance
The Pension Protection Act’s provisions surrounding 1035 exchanges have injected new life into non-qualified annuities by offering an innovative solution to funding long-term care.
The benefits include:
- Tax efficiency: Transferring funds from a non-qualified annuity to a long-term care insurance policy through a 1035 exchange avoids triggering immediate taxation.
- Enhanced care coverage: By redirecting annuity assets towards long-term care insurance, retirees can secure more comprehensive coverage tailored to their healthcare needs.
- Preserved income: Non-qualified annuities can generate a steady income stream during retirement. Using a 1035 exchange, you can allocate a portion of annuity funds to safeguard long-term care expenses while maintaining retirement income.
- Flexible allocations: If long-term care needs arise, reallocated funds can provide invaluable support; If they don’t, non-qualified annuities can continue to generate retirement income.
- Legacy Planning: When long-term care needs are minimal, remaining annuity funds can be preserved and potentially passed on.
While integrating non-qualified annuities with long-term care insurance through 1035 exchanges has substantial benefits, be mindful of certain considerations.
As with all finance decisions, your situation is unique—and what’s true about tax regulations today may not be so tomorrow. Consult with a professional to see if they have the right approach to help you fund your long-term care expenses.
FAQs
What are non-qualified annuities?
Non-qualified annuities are financial products in which individuals invest after-tax funds to receive periodic payments, typically during retirement. Unlike qualified annuities, these are not associated with tax-advantaged retirement accounts. Earnings on non-qualified annuities are subject to taxation, but they offer potential income and growth benefits over time.
Are annuities taxable?
Yes, annuities can be taxable. The tax treatment depends on whether the annuity is funded with pre-tax or after-tax funds and the type of annuity. Earnings on annuities funded with pre-tax money are taxed upon withdrawal, while those funded with after-tax money might have only a portion of withdrawals subject to taxation.
Are annuities tax-free?
Annuities are not inherently tax-free. Tax treatment depends on factors like the type of annuity, funding source, and purpose. Roth IRAs can offer tax-free growth and withdrawals, and some annuities might have tax-free components, but most annuities involve taxable income upon withdrawal or distribution of earnings.
What is the difference between a qualified and non-qualified annuity?
A qualified annuity is purchased with funds from a tax-advantaged retirement account like an IRA, 401(k), or 403(b). Contributions are often tax-deductible, but withdrawals are taxed as ordinary income. Non-qualified annuities are bought with after-tax funds. While earnings on both are tax-deferred, non-qualified annuities don’t have the same IRS contribution limits or withdrawal restrictions as qualified ones.
What’s the difference between a 1035 and 1031 exchange?
A 1031 exchange involves swapping one investment property for another to defer capital gains taxes. A 1035 exchange pertains to trading one insurance or annuity policy for another without incurring immediate tax liabilities. Both allow for the continuation of investments while deferring tax consequences, albeit within different domains (real estate vs. insurance).
