Tax rules and opportunities for LTC products under the pension protection act of 2006

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1 The Advanced Consulting Group White paper Tax rules and opportunities for LTC products under the pension protection act of 2006 Shawn Britt, CLU, CLTC Director, Long-term Care Initiatives, Advanced Consulting Group The Pension Protection Act of 2006, generally effective as of January 1, 2010, brought some positive changes to tax laws and Internal Revenue Code 1035 exchange rules that will hopefully help clients find more value in purchasing long-term care (LTC) coverage. These new rules have been in effect for several years now, yet there are still many misconceptions on applicability. The purpose of this paper is to bring more clarity to how these rules work as well as discuss potential planning opportunities and considerations. Tax law changes create new markets and planning opportunities for LTC/combo products and traditional LTC policies Life insurance and annuities have offered LTC riders for a while now, but with the tax law changes provided by the Pension Protection Act, new LTC combo products have emerged as more insurance companies see value in these combo offerings. When a client is younger, it may be difficult to have a discussion on long-term care planning. Even older clients approaching retirement may be hesitant to discuss long-term care. However, LTC/combo solutions on financial products offer new planning possibilities that clients may be more willing to embrace. For example: When working with younger clients still needing family protection through life insurance, adding a LTC rider may make sense as an inexpensive beginning to long-term care planning. The policy can transition from family protection now to LTC coverage later in life; and in the event the individual later becomes LTC uninsurable, at least some LTC coverage has been put in place. For clients purchasing life insurance for legacy enhancement, a LTC Rider can help protect a client s assets from being depleted due to long-term care expenses, or enhance their total legacy if LTC is little or never needed. When working with pre-retirees looking at annuity solutions, the addition of a LTC rider may offer additional value for clients hedging an income need with a potential long-term care need and/or for clients who are uninsurable for a life insurance policy but are still LTC insurable and want a leveraged solution that pays whether LTC benefits are needed or not. For clients who currently have life insurance policies or annuities they no longer find useful to their financial strategy, the cash value from these contracts can now be an IRC 1035 exchange into a traditional LTC insurance policy without recognizing taxable gain.

2 Life Insurance Old law vs. new law for life/ltc combo products Under the old law LTC benefits paid from LTC riders attached to life insurance were tax-free under the old law. However, past law dictated that when a life insurance policy was a MEC (modified endowment contract), and there were gains realized in the cash value of the policy, the cost of the rider (which reduces the cash value) would be considered a distribution and taxed as ordinary income. In addition, the cost of the rider was tax deductible as an IRC 213 tax deduction for medical expenses if the policy owner had met the required floor 1 of their adjusted gross income (AGI) existing at that time. On a non-mec life insurance policy, the cost of the rider would still be considered a distribution and the cost basis would be reduced by the cost of the LTC rider. As long as there was an existing cost basis, there would be no taxable event. But once cost basis was exhausted, the cost of the LTC rider was treated as a taxable distribution of gain. The most common reason for the cost basis to be totally exhausted would be when the policy owner had also taken other withdrawals of basis. The cost of the LTC rider was not deductible as a medical expense on a non-mec life insurance policy unless and until the cost basis in the policy had been exhausted. Under the new law for life insurance the following applies to LTC riders: 1. LTC benefits continues to be tax free The amount that may be collected tax free remains the same as before; which is the greater of the HIPAA per diem rate for the year LTC benefits are paid (for 2017 that amount is $360 per day or $10,800 in a 30-day month) or actual long-term care costs incurred. 2. The cost of a LTC rider is no longer considered a taxable distribution Under the new law the cost of a LTC rider is a non-taxable distribution under both a MEC and non-mec contract. However, under the new law, the cost of the LTC rider will reduce the cost basis but not below $0. Therefore, once the cost basis is exhausted, the cost of the LTC rider will continue to be treated as a nontaxable distribution. 3. The cost of a LTC rider is generally no longer tax deductible A IRC 213 tax deduction for medical expenses is no longer allowed for the cost of a LTC Rider (whether a MEC policy or non-mec policy) if the charge for the LTC rider is deducted from the cash value of the life insurance policy. Since most life insurance policies, other than whole life, take charges as a monthly deduction from cash value, taxpayers owning these types of policies will generally not be eligible for a IRC 213 tax deduction. Annuities Old law vs. new law for annuity/ltc combo products Under the old law Prior to the tax law changes, LTC benefits paid from an annuity with a LTC rider were treated in the same manner as any distribution from an annuity (last in first out, ( LIFO ) rules) thus the portion of the LTC benefit attributable to gain in the contract value was taxed as ordinary income. However, the cost of the rider was treated as a nontaxable distribution. While the LTC rider on an annuity may have provided attractive leveraging of LTC benefits, the LTC benefit was still a taxable distribution; thus it was not always seen by the consumer as advantageous in 2

3 comparison to other leveraged LTC coverage with tax-free LTC benefits. Under the new law the following applies to LTC riders on annuity contracts: 1. LTC benefits are now tax free The amount that may be collected tax free follows the same IRS formula as for all other LTC benefits; which is the greater of the HIPAA per diem rate for the year LTC benefits are received (for 2017 that amount is $360 per day or $10,800 in a 30-day month) or actual LTC costs incurred. Important Note: Not all annuity riders paying benefits for LTC related circumstances are tax free. A LTC rider may only pay tax-free benefits when the LTC rider attached to the annuity meets IRC standards for preferential tax treatment of LTC benefits under IRC 7702B. Some carriers refer to these riders as Pension Protection Act compliant. Individuals should consult the annuity contract to verify the tax qualification status of the rider. 2. The cost of the LTC Rider is not treated as a taxable distribution Under the new law, the cost of a LTC rider remains a non-taxable distribution. However, the cost basis of the annuity will be reduced by the cost of the LTC rider, though the cost basis can never go below $0. This can affect the annuity as follows: a. The lowering of the cost basis will increase gain in the contract, thus lowering the exclusion ratio on annuitization and causing a higher percentage of the income stream to be taxable. b. A lowering of cost basis leaves less cash value available as tax-free withdrawals if a withdrawal strategy is chosen over an annuitization strategy. c. The decrease in cost basis will result in an increase in gain, which will also create a larger taxable death benefit to beneficiaries. 3. The cost of the LTC rider is not tax deductible An IRC 213 tax deduction for medical expenses is not allowed for the cost of a LTC rider if charges for the LTC rider are deducted from the cash value of the annuity contract. Options on annuities that should not be mistaken for LTC benefits As noted above, not all riders or features on an annuity paying benefits for triggering events related to LTC conditions receive favorable tax treatment, or even pay out financial benefits. These types of features and options should not be represented as LTC or chronic illness benefits. For example: There are riders available on some annuities, that for an additional charge may (for example) double the guaranteed income received from an annuity should the annuitant be confined to a facility for long-term care. This rider is not a LTC or chronic illness rider, but is more of a kicker to enhance income under specific circumstances. These riders generally do not pay the extra income if the annuitant is only receiving home health care. Benefits are taxable in the same manner as the guaranteed annuity income since it is considered one in the same; and since these riders are not designed to meet the requirements for preferential tax treatment of IRC 7702B, they do not provide tax free benefits. Please read the annuity contract for details, but generally, these riders require that the policy be in force for at least one year before a claim is filed, and requires that the annuitant has been confined to a LTC facility for at least 90 continuous days before the enhanced income is available. Some insurance companies will waive any CDSC (Contingent Deferred Surrender Charge) associated with a distribution from the annuity contract if the distribution is being taken to pay for LTC expenses. For the waiver to apply to a distribution, it is generally required that the annuity contract be in force for at least 3

4 one year, and that the annuitant has received continuous care in a LTC facility for at least 90 days. The waiver usually does not include home health care as a triggering event. Please consult the specific insurance company contract for exact details. This feature offers no monetary benefit paid to the annuity contract owner and should not be confused with any riders that pay actual benefits. There is no tax consequence to waived charges. The actual withdrawal from the annuity will be taxed according to annuity rules. New IRC 1035 exchange rules The new rules under the Pension Protection Act now allow cash value from life insurance policies, endowment contracts and annuity contracts to be IRC 1035 exchanged to a traditional LTC policy without paying tax on the contract gains. This is a plus for people who own life insurance or endowment or annuity contracts that they no longer find valuable to their financial strategy and now desire coverage from a traditional LTC policy. This also makes annuity and life insurance contracts with LTC riders more flexible for an overall lifetime strategy. The addition of a LTC rider to such products may offer clients more flexibility should their future strategy change and a full bells and whistles traditional LTC policy be desired. The cash value from the life insurance policy or annuity contract, no longer needed, will be able to supply funding through an IRC 1035 exchange for a traditional LTC policy without the taxable consequences of recognizing gain in the contract. In the meantime, adding a LTC rider now to the life insurance or annuity purchase, puts something in place should the client become uninsurable in the future for a traditional LTC insurance policy. Despite the fact the applicable provisions of Pension Protection Act have now been in force since 2010, there is still much confusion on what constitutes a permissible IRC 1035 exchange. The first thing to keep in mind is that the base policy of the product being exchanged sets the basis for permissibility. Linked benefit (asset-based) LTC policies have probably contributed the most to this confusion. While a linked benefit policy is sold primarily for the purpose of LTC coverage, the base chassis of this product is either life insurance or an annuity. The death benefit from the life insurance portion of the policy, or the contract value from the annuity assures cost recovery (to a beneficiary) should the policy be little or never used for LTC benefits. Thus, a linked benefit policy will fall under rules of the product chassis it sits on when part of an IRC 1035 exchange. Another question that arises is whether an IRC 1035 exchange is affected in any way by the addition or deletion of a LTC rider or chronic illness rider from one policy to another; or whether a life insurance policy with a LTC rider can be exchanged for a life insurance policy with a chronic illness rider or vice versa. Again, permissibility of the exchange is determined solely on the chassis of the base product. The riders have no bearing on the exchange. The chart below illustrates allowable exchanges: Life Insurance Endowment Annuity LTCi Policy Life Insurance to YES YES YES YES Endowment to NO YES YES YES Annuity to NO NO YES YES LTCi Policy NO NO NO NO The Pension Protection Act clearly states that a traditional LTCi policy cannot be IRC Code 1035 exchanged into another LTCi policy. In addition, there is no cash value in these policies. While some traditional LTCi policies can be purchased with a return of premium feature (at a significant additional cost), this should not be confused with cash value. The return of premium feature on a traditional LTC insurance policy is not a rider for the benefit of the policy owner who may have buyer s remorse, but rather, a rider that pays a designated beneficiary in the event the policy is little or never used. The return of premium feature purchased on policies today varies by company, but generally pays an amount equal to: total premiums paid minus total LTC benefits received. However, some companies will offer riders that will base the formula for benefits paid to a beneficiary on double or even triple the cumulative amount of premium paid for the policy; but on a typical rider of this kind, once cumulative LTC benefits received equal the total of premiums paid, there is nothing left to return to a beneficiary. This feature assures that premiums will not be wasted should the policy get little or no use. 4

5 Tax free formula for LTC benefits The amount of LTC benefits (or chronic illness benefits) that may be received tax free, cumulative of all policies on an individual insured person remains the same as before; the greater of the HIPAA per diem rate (for 2017 that amount is $360 per day or $10,800 in a 30-day month) or actual long-term care costs incurred for the year benefits are paid. This formula applies to traditional LTCi policies as well as combo products such as LTC riders (and chronic illness riders) on life insurance and annuities; and also applies when multiple policies are paying benefits comprised of a combination of the afore mentioned products. The tax-free benefit, even if collected by a policy owner who is not the insured, is considered for tax formula purposes to be assigned to the insured. If multiple policies are owned on an individual insured, and that insured owns any of the policies, the insured will receive first access to any tax-free amounts. Any remaining tax-free benefit amounts as well as taxable benefit amounts will then be divided pro-rata between the other policy owners. If the insured does not own any of the policies, then there will be a pro-rata apportionment of tax-free and taxable amounts between the policy owners. Understanding IRS form 1099-R The Pension Protection Act also brought a change that includes new reporting requirements for life insurance companies. Now, anyone owning life insurance or an annuity with a LTC rider must receive a copy of IRS Form 1099-R reporting the cost of the LTC rider paid in that tax year. The cost basis in the life insurance policy or annuity contract will be reduced by the total cost of the LTC rider in that tax year. It s important to note that this amount is not taxable, nor is it reported on the tax return. Box 1 shows the total amount of LTC rider charges. Box 2 is where taxable amounts are normally placed, but will be blank because the LTC rider charges are not taxable. Box 7 shows a distribution code of W, indicating there is no need to report these amounts on the tax return. Box 8 shows the same amount as Box 1. This represents the amount that the cost basis on the policy was reduced based on the year s total LTC rider charges. While the IRS does not consider these charges taxable, they are considered a return of premium and thus reduce cost basis in the policy. Keep in mind it is possible to receive more than one IRS Form 1099-R for the same policy. For example, if there is a taxable distribution (such as a withdrawal of gain) another 1099-R would be provided showing a taxable amount in Box 2 for the taxpayer to report on his or her tax return. These documents should be carefully reviewed and a tax advisor consulted to ascertain whether these documents require the policy owner to report a taxable amount to the IRS. Understanding taxation resulting from a return of premium feature There are some life insurance policies with LTC riders and linked benefit LTC policies (also known as asset-based LTC) that offer return of premium features. It is common for linked benefit LTC policies to have no growth in cash value in the early years of the policy, yet if the policy is cashed in by means of a return of premium feature, there can still be a taxable event. As previously stated, the cost of the LTC rider reduces the cost basis in the policy; thus, gain in the policy is created, even when the policy owner only receives back the exact same amount of premium that was paid into the policy. The following is an example of how a taxable event could be created: An individual purchases a linked benefit policy with a single premium of $100,000. The policy has a 100% return of premium feature from day one. The policy is owned for six months, at which time the policy owner requests to surrender the policy and receive their money back. 5

6 During that six months of time, the total amount of monthly deductions taken from the cash value of the policy to pay for LTC rider costs amounted to $500. The insurance company refunds to this individual the full $100,000 paid into the policy. The policy owner receives IRS Form 1099-R reporting $500 of taxable income. Here is why: o Premium paid into the policy, and the initial cost basis is $100,000. o The $500 in LTC Rider charges reduced cost basis by $500. o At the time of policy surrender, the cost basis in the policy is $99,500. o Thus, a gain of $500 is realized and taxed as ordinary income. Qualifying for a long-term care claim All insurance companies offering solutions that are considered actual LTC products must comply with consistent standards set by regulatory requirements for long-term care to maintain a product s tax preferential treatment. This applies whether the policy is a traditional LTCi policy or a LTC rider on a life insurance policy or annuity. The regulatory requirements specific to claims include the following: The LTC claim is triggered when a U.S. licensed health care practitioner, operating within his or her own scope of practice, certifies the insured is either: o unable to perform two out of six activities of daily living for at least 90 days (eating, bathing, dressing, transferring, continence and toileting) or o has severe cognitive impairment A personalized Plan of Care by a licensed health care practitioner is submitted at the time of claim Annual claim recertification requirements are met Some insurance companies will pay for expenses related to the annual re-certification while other insurance companies will require the policy owner to pay any related costs. Tax deductibility of LTC expenses Out-of-pocket LTC expenses are considered medical expenses, therefore they potentially qualify for the IRC 213 tax deduction. However, due to the requirement for the taxpayer to meet the 10% 2 floor of the taxpayer s AGI for out-of-pocket medical expense, only LTC expenses or other medical expenses exceeding the required floor will realize a tax deduction. Keep in mind that when LTC benefits are received from insurance, only LTC expense amounts that exceed the amount of LTC insurance benefits received qualify for the potential tax deduction. Reimbursement policies only pay benefits equaling the lesser of the issued LTC benefit or actual LTC costs incurred. Therefore, any amount of LTC expense not reimbursed by insurance would potentially qualify for the Code 213 tax deduction. Indemnity policies do not reimburse expenses, thus an insured s LTC benefit could potentially exceed their actual LTC costs. In the case where LTC costs are equal to or less than the LTC insurance benefits received, there would be no opportunity for a tax deduction. However, if the insured has a spouse with no LTC insurance benefits, the spouse s LTC expenses would qualify for an IRC 213 tax deduction, even if excess benefits from the insured s LTC benefits were used to help pay for care. A tax professional should be consulted under such situations to ascertain what, if any, taxable events or potential tax deductions would apply. If LTC benefits are being received and the policy owner is not the insured, the insured s spouse, or other family member, a tax advisor should be consulted as there are situations in which a taxable event could occur. 6

7 Conclusion Today s LTC product choices offer your clients a variety of solutions, whether they a desire traditional LTC insurance policy, a life insurance/ltc combo that offers asset transfer possibilities with LTC protection, or an annuity/ltc combo that may provide an option for income in the future while keeping LTC funding options open. The choices are many, and the changes provided by the Pension Protection Act may offer your clients even more flexibility as they adjust their financial strategy in the future. 1 The required floor a taxpayer was required to meet before medical expenses could be deducted reached a high of 7 ½% at the time the tax law changes in the Pension Protection Act took effect. The current floor is now 10%. 2 The required floor in 2017 that a taxpayer is required to meet before medical expenses can be deducted is 10% FOR BROKER/DEALER USE ONLY - NOT FOR USE WITH THE GENERAL PUBLIC This material is not a recommendation to buy, sell, hold or rollover any asset, adopt an investment strategy, retain a specific investment manager or use a particular account type. It does not take into account the specific investment objectives, tax and financial condition, or particular needs of any specific person. Investors should work with their financial professional to discuss their specific situation. Federal income tax laws are complex and subject to change. The information in this paper is based on current interpretations of the law and is not guaranteed. Neither Nationwide, nor its employees, its agents, brokers or registered representatives gives legal or tax advice. You should consult an attorney or competent tax professional for answers to specific tax questions as they apply to your situation. Nationwide, the Nationwide N and Eagle and Nationwide is on your side are service marks of Nationwide Mutual Insurance Company Nationwide NFM-15390AO.1 (09/17) 7