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.
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.
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).
In short, 1035 exchanges allow the transfer; 7702(B)e defines which contracts qualify.
Here’s the step-by-step roadmap of implementation:
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:
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.
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.
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.
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.
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.
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).