The Pension Protection Act of 2006 provides a new method of financing the cost of long-term insurance policies, by combining them with life insurance and annuity policies and contracts. More particularly, the new allows for life insurance and annuity contracts to add long-term care insurance riders and use the cash value of the life insurance and annuity contract to cover the cost of long-term care insurance premiums without incurring taxable distributions. The new law also broadens Code Section 1035 to allow for tax-free exchanges of life and annuity policies into long-term care insurance contracts. The new provision does not come into effect right away - it applies only after 2009.
In effect, the long-term care insurance premiums can be paid from the cash surrender value and the untaxed build-up in value in the life insurance or annuity policy. Such payment is not treated as a distribution from the life insurance policy or annuity, which might otherwise be taxable to the owner.
There are some negative consequences to this treatment, which in many cases will negate the tax benefits. First, the payment of the premiums on the long-term care insurance is treated as a return of basis to the owner of the policy (but it will not reduce basis below zero). Since the owner may be taxed on future distributions from a life insurance policy that exceed the owner's basis, and the tax basis also measures the income of an annuitant from an annuity, such a reduction in basis may increase future income taxes. Second, the premium paid on the long-term care insurance will NOT be deductible under Code Section 213(a) as a medical expense deduction. Thus, if the owner had paid the long-term care insurance directly instead of through the life policy, he or she would not suffer the basis deduction, and may have a medical expense deduction.
In effect, the long-term care insurance premiums can be paid from the cash surrender value and the untaxed build-up in value in the life insurance or annuity policy. Such payment is not treated as a distribution from the life insurance policy or annuity, which might otherwise be taxable to the owner.
There are some negative consequences to this treatment, which in many cases will negate the tax benefits. First, the payment of the premiums on the long-term care insurance is treated as a return of basis to the owner of the policy (but it will not reduce basis below zero). Since the owner may be taxed on future distributions from a life insurance policy that exceed the owner's basis, and the tax basis also measures the income of an annuitant from an annuity, such a reduction in basis may increase future income taxes. Second, the premium paid on the long-term care insurance will NOT be deductible under Code Section 213(a) as a medical expense deduction. Thus, if the owner had paid the long-term care insurance directly instead of through the life policy, he or she would not suffer the basis deduction, and may have a medical expense deduction.
There are circumstances where such negative attributes are not really a problem. For example, the long-term care insurance may not be of a qualified nature, in which case no medical expense deduction would be available anyway even if the premium was paid directly by the owner. Or, if a life insurance policy is held until the death of the insured and substantial pre-death withdrawals are not made, the loss of tax basis in the policy is a nonevent.
Therefore, the particular circumstances of the situation will need to be reviewed to see if there is a benefit in using this new provision.
Life insurance and annuity companies will be subject to information reporting so that the IRS can track the payment of such premiums.
Applicable Code Sections: 72(e)(11), 1035, 7702B(b), 7702B(e), 6050U(a)
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