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1035 Exchange: Annuity to Long-Term Care Insurance

A 1035 exchange can let you pay long-term care insurance premiums using a tax-free transfer from an annuity. This technique can save on taxes while providing you with desirable coverage to protect against the financial impact should you ever require long-term care in a nursing home or other facility. However, not all long-term care insurance companies will accept payments via 1035 exchanges. And the procedure has to be done properly to avoid exposing you to a potential tax liability. Here’s what you need to know.

A financial advisor could help you put a financial plan together for your long-term care needs.

How 1035 Exchanges Work

The 1035 exchange was made by possible by a federal law, the  Pension Protection Act, that passed in 2006 but didn’t go into effect for four years. The law gave people a tax-advantaged way to pay for long-term care insurance by allowing funds from annuities to be used for insurance premiums.

Besides providing annuity holders with access to funds that can pay for long-term care insurance, a 1035 exchange offers significant tax advantages. It does this by giving annuity holders a way to avoid ever paying any federal income tax on the gains from investments made with the funds in their annuities. This is because the transfers, if done correctly, incur no federal income tax.

At the time the law passed, 1035 exchanges already allowed tax-free swaps of annuities purchased with after-tax dollars, known as non-qualified annuities, for different annuities. The 2006 change added annuity swaps for long-term care policies to the law.

Long-term Care Basics

1035 Exchange: Annuity to Long-Term Care Insurance

Long-term care insurance helps people experiencing disability, chronic illness, age-related infirmity or other long-lasting health condition pay the costs of staying in a nursing home or assisted living facility. It can also pay for other costs such as adult day care and in-home care.

Most costs covered by long-term care insurance are not medical costs, such as doctor visits and lab tests. Rather, they are costs incurred as a result of providing custodial and personal care as well as assistance with daily living activities. Long-term care insurance may, however, pay for nursing, physical therapy, occupational therapy or speech therapy.

Long-term care insurance premiums can be a significant financial challenge. In 2020, the American Association for Long-Term Care Insurance polled leading long-term care insurance companies and found that average annual premium for a healthy couple both aged 55 was $3,050. As policy holders get older and develop health problems, premiums rise. The same premium would just barely pay for a single 65-year-old woman with some health issues, the association found.

Risks and Limits of 1035 Exchanges

1035 exchanges of annuities for long-term care insurance can defer and ultimately avoid income taxes on annuity investment gains, but they are not without risks and other costs. One issue is the loss of the income stream that the annuity would otherwise provide. Many 1035 exchanges are not for the full amount of money in the annuity. Instead, only a portion is exchanged and used for long-term care premiums. However, even partial exchanges reduce the income the annuity will generate.

In addition, people doing 1035 exchanges may encounter surrender charges for taking money from their annuities to pay for long-term care policies. These surrender charges, which many annuities charge when money is withdrawn before a certain date, will reduced the amount available to pay for insurance.

Also, not all long-term care insurance companies will allow policyholders to use 1035 exchanges to pay premiums. Even if the insurance company will accommodate it, the exchange must be for a tax-qualified policy, which most long-term care policies are, and has to be from a non-qualified annuity purchased with after-tax dollars

Most importantly, to get tax deferment the exchange must be done directly. Funds must be exchanged from the annuity straight to the insurance company. If the annuity owner first withdraws the funds, then pays the insurance premium, the money may be treated as taxable income.

Bottom Line

1035 Exchange: Annuity to Long-Term Care Insurance

A 1035 exchange allows an annuity owner to use money in the annuity to pay for long-term care insurance premiums. If funds are exchanged directly from the annuity to the insurance company, the exchange is tax-free. Otherwise, it may be taxed as normal income. Using a 1035 exchange to pay for long-term care insurance means giving up at least some annuity income, and not all long-term care insurance companies will allow it.

Long-Term Care Tips

  • A financial advisor an help you evaluate the tax and investing consequences of a 1035 exchange. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
  • While having a tax-free way to pay for long-term care insurance is helpful, it still doesn’t guarantee you’ll be able to get coverage. The American Association for Long-Term Care Insurance said in 2019 that nearly 20% of 40- to 49-year-olds and nearly 54% of those over age 75 had their applications declined for health reasons.

Photo credit: ©iStock.com/kazuma seki, ©iStock.com/FatCamera, ©iStock.com/smartstock

Mark Henricks Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
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