Paying for long-term insurance with tax-free funds


The high cost of long-term care can quickly drain your savings, absorb most of your income and affect the quality of life for you and your family. Long-term care insurance (LTCI) allows you to share that cost with an insurance company. There are several tax-free options that can help you pay for LTCI.

Using a health savings account
A health savings account (HSA), is a tax-advantaged savings account tied to a high deductible health insurance plan. An HSA is funded with pretax contributions up to certain annual limits set by the IRS. Any growth inside an HSA is tax deferred, and what you don’t spend in one year can carry over to subsequent years. Just as importantly, withdrawals made from your HSA for qualified medical expenses are tax-free.

Tax-qualified LTCI premiums are a qualified medical expense eligible to be paid from HSA funds. The maximum annual premium you can pay tax-free is subject to long-term care premium deduction limits.

Convert taxable annuity to tax-free LTCI
Generally, withdrawals from a nonqualified deferred fixed annuity (premiums paid with after-tax dollars) are considered to come first from earnings, then from your investment (premiums paid) in the contract. The earnings portion of the withdrawal is treated as income to the annuity owner, subject to ordinary income taxes. IRC Section 1035 allows you to exchange one annuity for another without any immediate tax consequences, as long as certain requirements are met. Also the Pension Protection Act (PPA) extends the tax-free exchange of annuities for qualified stand-alone LTCI or combination fixed annuity/LTCI policies. This effectively allows you to purchase LTCI with annuity cash values that would otherwise have been taxable to you if withdrawn.

However, there are some potential drawbacks:

  • You may incur annuity surrender charges when transferring your annuity.
  • Transferring your annuity means you won’t have the potential income the annuity could provide.
  • While premiums for qualified LTCI are tax deductible as qualified medical expenses, annuity payments used to pay for long-term care are not tax deductible.
  • Not all long-term care policies allow you to pay premiums in a lump sum. You may need to make partial 1035 exchanges from the annuity to the LTCI company, but not all annuities allow partial 1035 exchanges.

HELPS Act may help
Part of the Pension Protection Act of 2006, the Healthcare Enhancement for Local Public Safety (HELPS) Retirees Act, allows certain retired public safety officers, including law enforcement officers, firefighters, chaplains and members of a rescue squad or ambulance crew, to make tax-free withdrawals from their retirement plans to help pay for LTCI for themselves and their respective spouses and dependents.

Eligible government retirement plans include qualified trusts, Section 403(a) plans, Section 403(b) annuities and Section 457(b) plans, Up to $3,000 per year may be withdrawn on a pretax basis, and the money must be paid directly from the retirement plan to the LTCI company. However, not all retirement plans may allow for these withdrawals, and some state laws may not allow the tax-free treatment of distributions.

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.

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