Repurposing Tax-Disadvantaged Assets into Tax-Free Long-Term Care Benefits

By Brian Gordon and Peter Florek

It’s difficult to know when or even if a client will need long-term care, but the odds improve as they age. The longer a person lives, the greater the chance they’ll need help due to chronic conditions or a traumatic event such as a stroke.

According to the National Association of Insurance Commissioners,¹ about 70% of people who reach age 65 are expected to need some form of long-term care, about half of them in a nursing home setting. Your clients who are approaching retirement or well into their retirement years need to be thinking about potential long-term care (LTC) needs and how they will pay for them. As their financial advisor, this is an important conversation to be having with them.

They likely have two other concerns: preserving their assets for their heirs while having to spend down their IRAs with the annual required minimum distribution (RMD) and paying taxes on those distributions. In fact, any pre-tax retirement account, whether IRA, 401(k), or 403(b), is just about the worst asset in an estate portfolio because the heirs must spend them down within 10 years and pay the resulting taxes. 

Pre-tax assets that made sense during their working years make less sense when a client reaches 73, the age at which they must start taking RMDs. Like IRAs, annuities grow tax-free but are taxable when they are redeemed. Consider, though, that with your help and that of a long-term care insurance (LTCI) specialist, a client can transform some of those potential tax liabilities into years of tax-free LTC benefits—and still leave a substantial estate. 

The LTCI industry responded to the rising cost of long-term care and LTCI premiums by creating hybrid products that combine straight annuities or whole life insurance annuities with LTC benefits. This article will look at some of those products and how they can leverage assets from a tax-disadvantaged retirement account into valuable LTC benefits worth many times more.

Hybrid Whole Life Insurance

Here’s our first scenario: The clients, both 62, were in good health and non-tobacco users. Concerned about one day needing LTC, they worked with us to reposition $200,000 of qualified funds from their IRA into an annuity-funding whole life policy designed to provide tax-free LTC benefits by allowing them to accelerate access to the death benefit. Funds not used for LTC will pass to their heirs as a tax-free death benefit. Their investment of $200,000 was augmented by a bonus from the carrier.

It's important to wait until a client is at least 59½ before implementing such a strategy to avoid early-withdrawal penalties from a pre-tax retirement account. They must pay taxes on the withdrawals, but taking money out of the account will reduce their heirs’ eventual tax liability.

If they need LTC, they can start drawing down the death benefit after Year 1 and receive $4,754 a month each in tax-free LTC payments. By the end of their 10-year premium period, they will have been eligible to receive nearly $1.5 million jointly in LTC benefits. Even if they live to age 95, their benefits are unlimited. This is a second-to-die policy; if no LTC benefits are used, the death benefit payable to their heirs will be $114,000, tax-free, after the second spouse dies.

So what has this done?

It has given the couple and their children peace of mind, knowing funds will be available for their LTC in a setting of their choice, whether that’s at home, in adult daycare, in assisted living, or in a long-term care facility.

It has saved the children from paying taxes on $200,000 from their parents’ qualified funds. If the parents so choose, they could use additional qualified funds to establish similar plans for their children, thus reducing the tax burden even further.

It has reduced the amount of money in the IRA that would be subject to the RMD.

It has preserved the rest of the couple’s estate because they haven’t had to draw down assets to qualify for Medicaid or self-pay for LTC.

Furthermore, it has leveraged an initial $200,000 investment into LTC worth several times that.

Hybrid Annuity

Here’s scenario number two: Another client had a huge gain in an annuity that became worth $2.2 million—which would be taxable after her death when her children redeemed it. As she was past the surrender date and wouldn’t incur a fee for a premature distribution, we “peeled off” $400,000 of the annuity and, using a 1035 exchange, purchased a hybrid annuity that provides tax-free LTC benefits, potentially up to $2.2 million, for six years or longer. This is a reasonable calculation because the average nursing home stay is about three years.

Uncle Sam will get his money one way or another. But if we assume a 28% tax bracket, we have saved $112,000 in taxes by removing $400,000 from the original annuity. The children will still owe taxes on the $1.8 million remaining in the annuity, but if their mom uses $2.2 million for LTC, her benefits are tax-free. 

What are the outcomes?

Rather than waiting for the need for LTC to arise and having to make a hasty decision, the client and her children know funds will be available for care in the setting of her choice.

An investment of $400,000 has been leveraged 3x to 5x, transforming it from a taxable asset into tax-free LTC benefits for six years or longer.

The lion’s share of the client’s estate has been preserved.

The family has been included in the decision-making and understands that although taxes will still be owed, they will be less than they would have been, and their mother will be cared for.

Important Points

The LTCI industry is complicated and ever-evolving, so it pays to have an LTCI specialist review a client’s potential needs and financial situation and then work with you to find the best options for that client.

However you proceed, there are a few critical things to remember:

The earlier a client can establish a hybrid LTC annuity or whole life policy, the lower the premiums will be. The ideal time is when they’re still in their 50s or, in the case of using qualified funds, at least 59½. Some products are available that a client can purchase in their 70s and 80s, but the leverage isn’t as attractive.

Make use of the 1035 exchange, which allows the transfer of funds from one tax-advantaged instrument, such as an annuity, to another like instrument without creating a taxable event. An annuity can’t be transferred to a life insurance policy or vice versa.

Involve the client’s children and other heirs when explaining how an LTC plan will work. A conference or Zoom call with everyone, including the financial advisor and LTCI broker, will go a long way toward mutual understanding.

Don’t let the client and their children dwell on the death benefit or inheritance. The reason for doing this is to help fund LTC.

Even robust LTCI may not cover all LTC expenses, depending on whether the client is cared for at home, in adult daycare, in assisted living, or in a nursing home. But it can cover a significant portion.

Many policies have a 90-day elimination period, during which the client is responsible for the cost of care, whether at home or in a facility. But policies vary widely. Make sure your client reads and understands the policy regarding elimination periods.

While premiums for standalone LTC policies are eligible for tax deduction under medical expenses, few taxpayers reach the threshold of 7.5% of AGI to be able to itemize. Premiums for hybrid policies are not deductible; however, the funds grow tax-deferred within the policies and annuities, and unused LTC benefits become a tax-free death benefit to heirs. This eliminates the common concern about LTCI premiums being “wasted.”

No one enjoys paying taxes, but taxes will still be paid nonetheless. Closely examining a client’s assets, evaluating the future potential need for LTC, and becoming familiar with strategies for transforming tax-disadvantaged assets into tax-free LTC benefits will save on taxes and help clients worry less about LTC expenses in the future.

Source:

¹ https://content.naic.org/sites/default/files/publication-ltc-lp-shoppers-guide-long-term.pdf

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Brian Gordon is president and Peter Florek is vice president of Gordon Associates, headquartered in Bannockburn, Ill., which was founded in 1975 by Brian’s father, Murray Gordon. Peter and Brian, a long-time supporter of NAPFA, each have over three decades of experience in helping families and businesses with their LTCI options. 

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