Do you own a life insurance policy that's no longer essential to your financial goals? You may have purchased a policy long ago when your children were infants or before their college years. Now that you're no longer raising a family, your focus has probably changed to your own future needs, which could include some form of long-term care. An extended nursing home or assisted living facility (ALF) stay could substantially erode — or even wipe out — your life savings.

Possible solution: You can trade in your life insurance policy or an annuity for a long-term care insurance (LTCI) policy. The exchange is exempt from federal income tax if specific requirements are met. That could put you in a better position to meet future financial challenges if you need to move into a nursing home or ALF later in life.

Background Information

The need in this country for some long-term care is on the rise. And with it, the need for LTCI coverage also continues to grow. Recent data provided by Ramsey Solutions should give you pause.

Significantly, if you're currently 65 years old, you have a 70% chance of requiring long-term care, while an estimated 20% of Americans will need care for longer than five years. Despite those daunting figures, only about 7.5 million Americans have LTCI policies.

What will long-term care cost? Be prepared for sticker shock. The average cost in the United States for one month in a nursing home is $7,698. According to the Alzheimer's Association, the estimated cost of care for the last five years of life is $367,000 for someone with dementia and $234,000 for those without. And the average American will pay $172,000 for long-term care.

Of course, the types of LTCI policies, and the resulting costs, can vary. Depending on the policy, it may provide benefits for different types of care, ranging from daily skilled care in an institutional setting to custodial care at home. Generally, you qualify for LTCI benefits if a physician certifies that you need assistance performing one of the usual "activities of daily living." These activities include bathing, eating, dressing, toileting, walking, and continence.

With some policies, benefits continue until you reach a certain maximum amount. Conversely, the benefits may last for a predetermined number of years. Or the policy may combine the limits and stop paying benefits when the maximum amount is reached, or the cutoff date occurs.

Consider the Tax Angles

Although you may purchase LTCI coverage outright, you might prefer to exchange a life insurance policy or an annuity for an LTC policy if you qualify. The tax law generally allows you to swap without any adverse tax consequences.

"Wait a minute," you may say. "Doesn't a recent tax law change prohibit these tax-favored exchanges?"

Not exactly. The Tax Cuts and Jobs Act (TCJA) indeed eliminated tax-free exchanges of like-kind properties, other than those of real estate, under Section 1031 of the tax code. But exchanges of life insurance policies or annuities for LTCI policies are governed by another tax code section. So the TCJA crackdown doesn't apply in this case.

The existing rules go back a couple of decades. Under Section 1035, you can exchange one life insurance policy for another, one annuity contract for another, or a life insurance policy for an annuity contract without triggering any taxable gain. (You can't exchange an annuity contract for a life insurance policy.)

In 2006, Congress added LTCI policies to that list of approved exchanges, effective beginning in 2010. This means you can use an existing life insurance policy or annuity to fund the purchase of a new LTC policy without immediate tax consequences.

You'll permanently avoid tax on the gain if you exchange an existing policy or annuity for a stand-alone LTCI policy. However, if you exchange it for a policy that combines LTCI benefits with life insurance or annuity benefits, any gains that become part of the new policy's cash value or annuity payouts may eventually be taxed. In addition, special rules apply to partial exchanges of annuities for LTCI policies, including a 180-day waiting period before withdrawing from the annuity.

Here's an example: Nick has a life insurance policy with a $200,000 cash surrender value and a $100,000 tax basis. He exchanges it for a $200,000 single-premium, stand-alone LTCI policy. Before 2010, Nick would have owed tax on the $100,000 gain. But under current law, this is exempt from income tax. If the insurance company didn't offer single premium policies, Nick could have financed the purchase using a series of partial tax-free exchanges to meet his annual premium obligations.

To execute an exchange, you must arrange a direct transfer of funds from one insurance carrier to the other. If you take possession of the funds — no matter how briefly — you'll be treated as if you'd made a taxable surrender of the policy or contract. Unlike an IRA, there's no "rollover" option for tax-free exchanges.

A Word of Caution

Exchanging a life insurance policy or annuity for an LTCI policy can be challenging. You'll have to find a financial institution that will accommodate your needs, and you could face underwriting obstacles. The number of companies that provide LTCI policies — never mind facilitating exchanges — is limited. You may acquire a policy directly instead if you can't find a suitable match.

Even so, it's a good idea to weigh the benefits of obtaining LTCI coverage. Contact an R+R tax advisor to discuss options for long-term care coverage and tax implications to determine which solution best suits your needs.

Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve. Our mission is to operate as a financial services firm of outstanding quality. Our efforts are directed at serving our clients in the most efficient and responsive manner possible, delivering services that exceed the expectations of those we serve. The firm has offices at 90 Grove St., Ridgefield, Conn., and 51 Locust Ave., New Canaan, Conn. For more information, please contact Elizabeth Bresnan at 203.438.0161 or email.    


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