Tax-free exchanges to pay for long-term care insurance

At least 70 percent of people over the age of 65 will require some level of long-term care, according to insurance company Genworth Financial's 2016 Cost of Care Survey. And that care can be very expensive.

For example, per month on average, it costs $3,628 for care in an assisted-living facility, $3,861 for a home health aide and $7,698 for a private room in a nursing home, according to Genworth. How might you pay for this without exhausting your savings?

Long-term care insurance can be an effective way to protect your nest egg against these expenses and preserve it for the next generation, but premiums for these policies can be expensive. Here's where your life insurance policy could enter in. A tax-free exchange using your life insurance policy can be a cost-efficient strategy for funding long-term care premiums.

Partial or hill exchanges allowed

Historically, the IRS permitted taxpayers to exchange certain policy types without a tax cost: one life insurance policy for another, one annuity contract for another or a life insurance policy for an annuity contract. Notably, the exchange of an annuity contract for a life insurance policy wasn't granted favorable tax status.

The rule later was expanded to allow partial tax-free exchanges and, more recently, long-term care contracts were added to the permissible list. So, it's now possible to make a total or partial tax-free exchange of a life insurance policy or annuity contract for a long-term care policy, as well as one long-term care policy for another. But there are some restrictions.

For example, to avoid negative tax consequences after making a partial exchange of an annuity contract for a long-term care policy, you must wait at least 180 days before taking any distributions from the annuity.

Tax benefits are significant

A tax-free exchange provides a source of funds for long-term care coverage and offers significant tax benefits. Ordinarily, if the value of a life insurance policy or annuity contract exceeds your basis, lifetime distributions include a combination of taxable gain and nontaxable return of basis. A tax-free exchange allows you to defer taxable gain and, to the extent the gain is absorbed by long-term care insurance premiums, eliminate it permanently.

Consider this example: Joan, age 72, is concerned about possible LTC expenses and plans to buy an LTC insurance policy with a premium of $10,000 per year. She owns a nonqualified annuity (that is, an annuity that's not part of a qualified retirement plan) with a value of $250,000 and a basis of $150,000, and Joan wishes to use a portion of the annuity funds to pay the LTC premiums. Under the annuity tax rules, withdrawals are treated as "income first." In other words, the first $100,000 she withdraws will be fully taxable and then any additional withdrawals will be treated as a nontaxable return of basis.

To avoid a taxable gain, Joan uses partial tax-free exchanges to fund the $10,000 annual premium payments. In an exchange, each distribution includes taxable gain and basis in the same proportions as the annuity. In this case, the gain is ($100,000/$250,000) * $10,000 = $4,000. Thus, each partial exchange used to pay long-term care premiums permanently eliminates $4,000 in taxable gain.

Partial tax-free exchanges can work well for standalone long-term care policies, which generally require annual premium payments and prohibit prepayment. Another option is a policy that combines the benefits of long-term care coverage with the benefits of a life insurance policy or an annuity.

Typically, with these "combo policies," the death or annuity benefits are reduced to the extent the policy pays for long-term" care expenses.

Norman G. Grill is a certified public accountant and managing partner of Grill & Partners LLC, CPAs and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien. He can be reached at203-254-3880 or at [email protected]