In 2019, the U.S. Department of Health and Human Services (HHS) projected that 70% of those 65 and above would need some type of long-term care (LTC) services. The HHS and the Department of Labor also forecast the number of people requiring LTC will reach 27 million by 2050.
Though demand for long-term care is increasing (and is projected to further increase), the associated costs are not reducing. Instead, they’re on the rise.
Consequently, many U.S. adults have embraced long-term care insurance (LTCI) as a way to address the cost of LTC and reduce out-of-pocket expenses. However, premiums for LTCI can also be very expensive — especially when compared to traditional health insurance plans.
Nevertheless, LTCI remains indispensable for many U.S. adults, and obtaining coverage can provide support for them and their loved ones when they can no longer perform activities of daily living.
One way to help pay for the costly premiums is for those with non-qualified annuities to exchange such annuities for LTCI in a process called a 1035 annuity exchange.
In this article, we will consider how those with matured non-qualified annuities (and who don’t want to cash in on them) can exchange them for LTCI.
1035 Annuity Exchange
A non-qualified annuity is an annuity invested in using after-tax dollars instead of pre-tax dollars.
Because the contributions to the annuity have been taxed, those funds cannot be taxed again at withdrawal. Only the earnings on non-qualified annuity contracts will be considered ordinary taxable income.
But a non-qualified annuity can be exchanged for another annuity, in which case neither the investment itself nor the earnings will be subject to tax. This exchange, called a 1035 annuity exchange, is permitted under Section 1035 of the Internal Revenue Code (IRC).
There are various reasons why people exchange one annuity for another, including because:
- They’re moving from a fixed to a variable annuity, or vice versa.
- They’re moving to an annuity with better features.
- They’re moving to an annuity with lower premiums.
- The new annuity has more investment options.
- The new annuity charges lower fees.
- The company holding the old annuity is no longer financially viable.
No matter the reasons for the exchange, a 1035 annuity exchange and its tax benefit can present a better choice than cashing in on an unwanted annuity and then using the money to buy a new one. While the former (the 1035 exchange) is tax free, the latter is not.
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Non-Qualified Annuity for Long-Term Care Insurance
By the provisions of the Pension Protection Act, the features of the 1035 annuity exchange have applied to LTCI since January 1, 2010.
In essence, a non-qualified annuity can be exchanged for a long-term care insurance policy. If an annuity owner believes they would be better served by a LTC policy, they can exchange their annuity for it instead of cashing out on that annuity and paying tax on its earnings.
Full and Partial Exchange
The exchange can be done in two ways: a full exchange or a partial exchange. A full exchange occurs when the annuity’s lump sum cash surrender value is exchanged for the insurance plan. Not all LTCI plans, however, allow full exchanges.
The alternative is a partial exchange. Here, a portion of the annuity’s cash surrender value will pay the premiums payable on the insurance plan. This process will be repeated until the funds in the annuity are exhausted. But not all annuities accept partial exchanges, and not all insurance companies are prepared to implement them.
Conditions for the Exchange
There are certain conditions the annuity owner must meet before the exchange can be successfully completed:
- The annuity owner, beneficiary and annuitant on the non-qualified annuity must be the same as those on the LTCI plan.
- The exchange must be a direct transfer. Cashing out the annuity and then using the cash to purchase the insurance plan does not qualify as a 1035 annuity exchange.
- For the tax benefit to apply, the annuity must be a non-qualified annuity.
- Finally, the LTCI plan must also meet the requirements of HIPAA and the IRS:
- It must have no cash surrender value.
- Benefits from the policy cannot pay for expenses covered by Medicare.
- It must offer coverage for only qualified long-term care services.
- It must be guaranteed renewable.
- Refunds or dividends should only be used as a reduction in future premiums or as an increase in future benefits.
In addition, it is important to emphasize the following points as it relates to this exchange:
- An annuity owner can exchange more than one annuity for the same LTCI plan
- If the insurance plan is jointly owned, an exchange cannot occur
- The exchange may incur some surrender charges, depending on the annuity provider.
Benefits of the 1035 Exchange
Should you consider exchanging your non-qualified annuity for a LTCI plan?
- No Taxation on Earnings
- Withdrawing from your non-qualified annuity will traditionally result in taxation on the earnings component (based on the Last in First Out principle). But with a 1035 exchange, there is no tax even on earnings.
- No Taxation on the Long-Term Care Insurance Plan
- Also, the LTCI plan receiving the funds from the non-qualified annuity is not taxable as it is treated as an accident and health insurance contract.
- Enjoying Long-Term Care Without Putting Pressure on Savings and Investments
- Long-term care is expensive and even premiums on long-term care insurance can be cost-prohibitive. But with an exchange like this, annuity owners can avoid dipping into their other savings.
- Remaining Cash Surrender Value Can Be Spent
- If the annuity owner uses a partial exchange and the premiums on the LTCI plan do not exhaust the cash surrender value of the annuity, the remainder can be withdrawn and spent (although generally subject to taxes.
- Reducing the Tax Paid on Cash Surrender Value
- The earnings portion of the remainder of the cash surrender value that is withdrawn will be taxed.
Below are the benefits of such an exchange:
However, because partial exchanges are removed from both the earnings and the investment portion on a prorated basis, every exchange reduces the earning portion and thus the amount that is taxable at withdrawal.
For example, suppose there is an annuity with $150,000 of which $100,000 is the investment portion and $50,000 is the earnings portion. In this case, every partial exchange will be prorated in the 2:1 ratio between investment and earnings.
So, if the owner exchanges $27,000, $18,000 will be deducted from the investment portion and $9,000 from the earnings portion.
To qualify as a tax-free partial 1035 exchange, you cannot take a distribution from either contract within 180 days of the exchange.
Because the earnings portion (which is the taxable portion) is also reducing with every exchange, the amount of tax payable at the time of withdrawal would have been minimized (compared to if every partial exchange is deducted only from the investment portion).
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Drawbacks of the 1035 Exchange
- It Might Not Be Possible
- As said above, not all annuities allow partial exchanges and not all long-term care insurance policies allow full exchanges. Finding an annuity and a long-term care insurance policy that align in terms of their requirements can be difficult. Also, some deferred annuities may not allow this exchange.
- It Might Be Costly
- Annuity surrender charges may apply depending on the annuity provider. The charge varies, and it can be expensive with some providers.
- It’s a Withdrawal From Future Income
- Any money taken from an annuity is money that could have grown and gained compound interest into the future
- Paying Premiums May Provide Better Tax Benefits
- The benefit of this exchange is avoiding paying expensive premiums for a LTCI policy. But such premiums are partially tax-deductible, so it remains to be seen if the tax benefits of avoiding those premiums (through a 1035 exchange) are greater than you’d receive by paying them.
To get a full perspective, let’s also consider the drawbacks of exchanging a non-qualified annuity for long-term care insurance:
For taxable years starting in 2024, qualified LTC premiums can be included as medical care expenses up to the amounts below:
| Age Before Close of Taxable Year | Includible Up To |
|---|---|
| Age 40 or Under | $470 |
| Age 41 to 50 | $880 |
| Age 51 to 60 | $1,760 |
| Age 61 to 70 | $4,710 |
| Age 71 and Over | $5,880 |
The limit on the premium listed is per individual.
Should You Make the Exchange?
Answering this question is not straightforward. There are certain factors that every individual considering the decision should consider.
First, do you have enough money to pay the premiums for a long-term care insurance policy? If you do, then it may be better to take the tax benefits of such premiums and keep your annuity for its future benefits.
However, if you are considering terminating your annuity contract, then you should compare the tax benefits of a 1035 exchange with the tax benefits of paying premiums for a LTC policy from your income. If the former is higher, then it is better to continue with the exchange. If the situation is reversed, then it is better to pay the premiums out of your income and surrender your annuity (paying tax on the earnings portion).
Second, if LTCI is important to you and you don’t have the resources to pay premiums for an insurance policy, then continue with the exchange unless you are confident that the future returns on your annuity will be enough to pay for your long-term care without insurance.
In the end, your financial advisor is best poised to give you a personalized recommendation regarding the best way to proceed.
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