478 / Can a life insurance policy or annuity contract be used to provide long-term care coverage?

A life insurance or annuity contract may provide long-term care insurance benefits. Any long-term care insurance coverage, qualified or otherwise, that is provided by a rider or as part of a life insurance or annuity contract will be treated as a separate contract for purposes of the treatment of long-term care benefits paid.¹ As such, benefits paid for qualified long-term care services are generally tax-free (regardless of the treatment otherwise applicable to a withdrawal from the underlying life or annuity contract) ( Q 491).²

Planning Point: By linking two distinctly fundamental needs, such products have earned the moniker “combination”, “hybrid”, “linked-benefit” or “asset-based long-term care”. There is no legal difference in these terms, which were instead born of marketing. (The IRS employs the term “combination contracts”.)

There is no premium deduction permitted under IRC Section 213(a) for charges made against the cash surrender value of a life contract or cash value of an annuity contract which pay for qualified long-term care insurance (QLTCI).³ Rather, such charges serve to reduce the investment (i.e., cost basis) in the underlying contract by the amount of the charge—but not below zero. Since these charges are withdrawn from the policy’s cash value to pay for the QLTCI (albeit internally), they are considered “distributions”. Nevertheless, the amount of these charges is not included in gross income.⁴

Planning Point: In certain situations, a combination policy may be a modified endowment contract, or MEC. (Generally, most single-premium life combo products are MECs, i.e., they fail the seven-pay test.) When they were first established in 1988, MECs received less favorable income tax treatment than non-MECs: |

• Distributions (including withdrawals and loans) are received taxable gain first, tax-free principal last (LIFO), and
• Any distributions received prior to age 59½ are subject to a 10 percent penalty (unless taken for death, disability or as part of a life annuity).

The above MEC rules (LIFO tax treatment of distributions, and the 10 percent early withdrawal penalty) are the same treatment found in nonqualified deferred annuities. However, the Pension Protection Act (PPA) modified these rules effective January 1, 2010. Specifically, the PPA targeted distributions from life insurance (even MECs) and nonqualified annuities when used to pay for QLTCI: going forward, they would not be subject to immediate taxation or the early withdrawal penalty. Instead, these charges would simply reduce cost basis in the contract (but not below zero). To be clear, the linchpin of this favorable tax treatment is the requirement that the qualified long-term care coverage be made part of (or included as a rider on) the life or annuity contract from which cash value charges are made.

None of the tax provisions cited above for combination life/long-term care or annuity/long-term care policies apply to any of the following:⁵

(1)     A tax-exempt (under a Section 501(a)) trust described in IRC Section 401(a) ( Q 3837));

(2)     A contract purchased by a tax-exempt (under a Section 501(a)) trust described in IRC Section 401(a));

(3)     A contract purchased as part of a plan under IRC Section 403(a);

(4)     A contract described in IRC Section 403(b) ( Q 4027);

(5)     A contract provided for employees of a life insurance company under IRC
Section 818(a)(3);

(6)     A contract from an IRA or individual retirement annuity ( Q 3641); or

(7)     A contract purchased by an employer for the benefit of an employee or an employee’s spouse.

1.     IRC § 7702B(e)(1).