American seniors are increasingly finding value in fixed-indexed annuities. According to the Insured Retirement Institute, roughly half of the investors currently or previously owned an annuity. Sales have been growing, no doubt, due to a combination of aging adults planning for retirement and increasing interest rates.
There are two types of annuities: qualified and nonqualified. A qualified annuity is funded with pretax money, and withdrawals are subject to ordinary income tax. Non-qualified annuities are purchased with after-tax dollars. Any earnings thus grow tax-deferred until withdrawn, providing a potentially significant tax advantage. Seniors potentially increase their retirement savings by delaying the payment of taxes on their earnings until they are in a lower tax bracket.
The majority of individuals purchase non-qualified annuities to protect their retirement savings. A 2022 Gallup survey of annuity owners found that 81% intended to use their annuity for retirement income. 84% cited owning the annuity as a financial cushion in case they live beyond their life expectancy and need costly care, such as long-term care.
Using An Annuity To Pay For Long-Term Care
Tapping a non-qualified annuity to pay long-term care expenses can have unexpected tax consequences. Money withdrawn from an annuity can be taxed as ordinary income. According to data compiled by the American Association for Long-Term Care Insurance (AALTCI), non-qualified annuities use last-in, first-out (LIFO) tax rules. Simply put, earnings are taxed first; thus, the tax liability tends to be higher in the early years.
For example, a couple purchased a non-qualified annuity when they were 60. The initial premium, or amount paid, was $75,000. Some 25 years later, the annuity’s value has grown to $152,000 according to AALTCI, an annualized growth rate of 3%. One spouse, now age 85, needs long-term care and they start withdrawing funds to cover expenses. The first $77,000 withdrawn will be considered ordinary income and subject to taxation.
Recognizing that many seniors do not own long-term care insurance, the federal government has approved several ways seniors can minimize the tax consequences. At the same time, several major insurance companies offering non-qualified annuities now offer policies that significantly increase the amount of funds available for long-term care needs.
Annuities That Minimize Tax Consequences and Maximize Potential Benefits
Since 1997, the federal government has offered tax breaks to purchase qualified long-term care insurance policies. Benefits received to pay for long-term care services are generally not counted as income. While most non-qualified annuities do not meet the requirements, several now report AALTCI, the long-term care industry’s advocacy organization.
Converting a current non-qualified annuity into one that meets the IRS requirements can be accomplished via a 1035 exchange. A 1035 exchange is a provision of the Internal Revenue Service (IRS) code allowing for a tax-free transfer of an existing annuity contract, life insurance policy or endowment for another one of like kind.
Using the prior example, AALTCI reports that a couple would use a 1035 exchange to switch from their current annuity into another annuity that meets the qualifications so that withdrawals for long-term care are received tax-free. The even more significant benefit is that some newer policies offer significantly higher potential payouts for long-term care expenses.
Another example AALTCI shared reflects a couple aged 70 with a non-qualified annuity valued at $150,000. The illustration assumes they use a 1035 exchange to switch into an annuity, offering added benefits for long-term care needs. Growing at the minimum guaranteed interest rate, the AALTCI report indicates that the couple will have $460,912 available at age 90. Left in place, their current traditional annuity’s value without the added leverage for long-term care will be worth an estimated $181,000.
Who Should Consider A 1035 Annuity Exchange?
This ideal planning strategy for individuals between ages 60 and 75, especially those without long-term care insurance, suggests AALTCI’s linked-benefit long-term care experts. The organization reports that some of the best long-term care annuities accept a maximum age of 80. A non-qualified annuity should be worth at least $100,000 to make the exchange worthwhile, suggest their experts. The surrender period they note, when the contract is subject to a penalty charge for withdrawals or closure, should be over.
While all non-qualified annuities can be used to pay for long-term care expenses, only a few meet the requirements permitting complete tax-free withdrawals and the added leverage for LTC payouts. A knowledgeable long-term care insurance professional versed in traditional and linked-benefit policies can be an excellent resource. The AALTCI provides an annual Price Index that provides current costs for long-term care insurance.
Be sure to ask the agent or advisor with whom you work if they have executed the 1035 exchange and recommend AALTCI. Undertaking an exchange incorrectly can subject you to tax consequences. Also, ask for the company’s history of interest rate crediting. While the first-year interest rate will generally be very attractive, the insurer sets rates for subsequent years.
About Jesse Slome
Medicare Expert – Director Long Term Care Insurance Association, Medicare Supplement Insurance & Critical Illness Insurance Association