The Pension Protection Act of 2006 – How it Relates to Long-Term Care Financing and Planning

As a result of the Pension Protection Act of 2006 that went into effect on Jan. 1, 2010, policyholders with specially designed annuities have the ability to take cash value withdrawals for qualifying long-term care expenses, free of income taxes, regardless of the cost basis. Benefit payments from LTC insurance riders and cash value withdrawals to pay for LTC insurance premiums also are not taxable.

The Act clarified that, effective Jan. 1, 2010, LTC insurance benefits paid out of these plans (even if a portion of those serves to reduce account values in the underlying annuity) are paid as tax-free LTC insurance benefits. This is unprecedented in the annuity world; prior to that date there was no mechanism that allowed for gains in a contract to be paid out on a tax-free basis. In addition, the law also allows for 1035 exchanges into combination plans.

The Act specifically allows annuity and life insurance contracts to contain or be combined with LTC features. The new rules also grant favorable tax status to certain features of LTC contracts that are so combined. One important limitation to note is that the new rules are generally inapplicable to contracts held by qualified retirement plans.

The Act provides for new rules regarding the use of a combined contract’s overall cash value to fund the long-term care portion of the contract. Charges that are assessed against the life or annuity contract’s cash value that fund a long-term care rider are excluded from gross income. Under prior law, these were treated as taxable distributions. In short, the Act allows LTC insurance to be paid from the cash value of life insurance and annuities on a before tax basis. Payment made in this manner will, however, reduce the investment in the contract. In addition, any such payment will not be deductible under Code Section 213. These limitations do not change the fact that the new rules will allow a significant tax advantaged method of paying for LTC.

Section 1035 of the Code was amended to allow for tax-free exchanges of life insurance contracts, annuity contracts, endowment contracts and qualified LTC contracts for qualified LTC contracts. In addition, the Act clarifies that life insurance and annuity contracts containing long-term care features will be eligible for tax-free exchange treatment.

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