Section 1035 exchange
Generally, withdrawals from a nonqualified deferred annuity are considered to come first from earnings, then from your investment in the contract. The earnings portion of the withdrawal is treated as income to the annuity owner, subject to ordinary income taxes. IRC Section 1035 allows you to exchange one annuity for another without any immediate tax consequences. However, prior to 2010, an annuity couldn't be exchanged for a long-term care insurance policy on a tax-free basis. But the Pension Protection Act changed that and, as of January 1, 2010, both life insurance and annuities may be exchanged, tax free, for qualified long-term care insurance.
Conditions for tax-free exchange
In order for the transfer of the annuity to the long-term care insurance policy to be treated as a tax-free exchange, certain conditions must be met:
- The annuity must be nonqualified, meaning it cannot be part of an employer-sponsored retirement plan.
- The long-term care insurance policy must meet the requirements of the Health Insurance Portability and Accountability Act (HIPAA) and IRS criteria.
- The exchange must be made directly from the annuity issuer to the long-term care insurance company. You will not receive tax-free treatment if you withdraw funds from the annuity directly, then use them to pay the long-term care insurance premium.
Potential tax advantages
Exchanging your nonqualified deferred annuity for a long-term care insurance policy may have several tax-related advantages. You can use annuity earnings to pay for long-term care insurance without paying income tax on those earnings. This allows you to use otherwise taxable annuity earnings in a more tax-efficient manner.
Another advantage relates to the long-term care insurance policy. Generally, a qualified long-term care insurance policy is treated as an accident and health insurance contract, and the benefits are typically treated as tax free, subject to certain limits. In this way, you may be able to use tax-free annuity earnings to pay for tax-free long-term care benefits.
Other possible benefits
Aside from the favorable tax treatment, there may be other benefits as well.
- Using an annuity to pay for long-term care insurance may lessen the need to tap other savings or income to pay for premiums.
- You may still use any remaining cash surrender value of the annuity for other income needs or expenses.
Some potential disadvantages
There are also some potential disadvantages to exchanging an annuity for long-term care insurance.
- Reducing the annuity's value to pay for long-term care insurance premiums may reduce your ability to use the annuity to provide income needed in the future.
- If you exchange the annuity for a long-term care insurance policy, your survivors won't have the annuity's cash value for income or savings that otherwise would have been available at your death.
