Limited Tax Benefits for Long-Term Care Insurance Found in Pension Protection Act

On its face, the Pension Protection Act of 2006 (PPA) encourages the purchase of long-term care insurance by allowing policyholders to take tax-free distributions from their life and annuity policies to pay their long-term care insurance premiums (Section 844). But in an attempt to prevent taxpayers from receiving a double tax benefit, Congress included a provision in the PPA that prevents taxpayers from first avoiding taxes on payments out of a life or annuity policy and then taking a deduction for those payments when calculating gains on the life insurance policy.

According to Michael Kitces, who writes for Steve Leimberg's Employee Benefits and Retirement Planning Newsletter, this provision, effective after 2009, has in fact created the opposite problem: when life or annuity policies are used to pay long-term care premiums, both the cash value and the cost basis of the life or annuity policy are reduced by the amount of those charges. Without the additional tax deduction when it comes time to determine the gain on future distributions from the policy, this tax structure ultimately zeroes out any potential tax benefit of using life or annuity insurance policies to pay long-term care premiums.

"[I]t will be rare that an individual would actually be well-served for tax purposes to purchase a long-term care insurance rider on a life insurance or annuity contract," Kitces observes. The only case where it would be useful, he says, is if the contract's cost basis is already very close to $0, since charges deducted from the cash value to cover long-term care insurance premiums cannot be reduced below zero.

Despite this tax drawback, retirement planners may still see increased demand for long-term care contracts because of a provision in the PPA that allows tax-free exchanges between life or annuity policies and long-term care contracts. Kitces warns that tax planners should continue to perform due diligence on the exchange, because the existing life or annuity policy may have specific benefits and guarantees that the long-term care contract will not, which would limit the exchange's overall value.

Attorneys also should be aware that all riders and exchanges must be with qualified long-term care insurance contracts. To qualify, the individual must receive a plan of care prescribed by a health care practitioner, and the practitioner must certify the holder as "chronically ill," which means unable to perform at least two activities of daily living.

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