492 / Can an annuity contract or life insurance contract be exchanged for another contract containing a long-term care rider in a nontaxable exchange?

As a result of the Pension Protection Act of 2006 (PPA), which went into effect January 1 2010, tax-qualified (TQ) long-term care insurance (LTCI) is now included in the scope of the Section 1035-exchange rules. This means that life, endowment, annuity and qualified LTCI may all be exchanged for qualified LTCI.

In addition, the presence of a qualified LTCI rider on a life or annuity contract will not cause it to fail to qualify for the purposes of such an exchange. In other words, a taxpayer can exchange an annuity without a long-term care insurance rider for an annuity with such a rider, and still qualify for non-recognition treatment.¹

In sum, the IRC provides that the following exchanges are nontaxable:

(1) the exchange of a life insurance policy for another life insurance policy (with or without a qualified LTC rider), for an endowment or annuity contract (with or without a qualified LTC rider), or for a standalone qualified long-term care insurance contract;

(2) the exchange of an endowment contract for an annuity contract (with or without a qualified LTC rider), for an endowment contract under which payments will begin no later than payments would have begun under the contract exchanged, or for a standalone qualified long-term care insurance contract;

(3) the exchange of an annuity contract for another annuity contract (with or without a qualified LTC rider); or for a standalone qualified long-term care insurance contract; and

(4) the exchange of a long-term care insurance contract for another qualified long-term care insurance contract.²

Planning Point: Neither an annuity nor a standalone qualified long-term care insurance contract can be non-taxably exchanged for a life insurance policy (with or without a qualified LTC rider).

Generally, if an individual surrenders an “old” contract and uses the proceeds to purchase a “new” contract, they are required to recognize any gain over basis as ordinary income for federal tax purposes. But if certain requirements are met, Section 1035 allows them to avoid any recognition of gain. (Among these requirements are that the exchange must take place in a “hands-off” fashion directly between the two insurers. The taxpayer must not receive the proceeds, even if later used to purchase the new contract.)

Planning Point: Under Section 1035, both the owner and insured under the original contract and the new contract must be identical. For instance, an individually-owned contract cannot be 1035-exchanged into a jointly-owned contract.

Planning Point: Such exchanges may be appropriate when the owner of a life or annuity contract no longer has the need associated with the original contract (wealth accumulation), but does have a long-term care need (wealth protection).

1035-exchanges can be either “full” or “partial.” One might employ a “full” exchange when funding a single-pay product such as a combination product, and a “partial” for a limited payment mode such as a 10-pay. As a practical matter where LTCI is concerned, very few carriers are comfortable accepting partial exchanges on this basis from neighboring carriers. Logistically, it is preferable to move all the products under one financial “roof.”

Planning Point: The annuities covered by Section 1035 must be non-qualified, and cannot be owned by a trust or corporation. If the annuity is still within its surrender charge period, or the amount to be exchanged exceeds any free withdrawal limit, such amounts will be subject to a surrender charge. If a deferred annuity does not have any gain (as could be the case with a variable annuity in a down market), then there may be little tax benefit to exchanging the annuity for TQ LTCI.

Having said that, the ability to “wash” gain on non-qualified annuities through either QLTCI or combination products with QLTCI riders is a remarkable tax advantage, and a loophole which may not last forever.