Taxation of a Combo LTC Annuity

A combo LTC annuity is an annuity that contains a long-term care insurance option. If the annuitant/owner meets the requirements for long term care payout from the policy, the cash in the policy will pay out monthly, a certain amount of money to be used for long term care services. If there is a surrender charge on the policy, that charge will be eliminated if the long-term care payout option is triggered.

The Pension Protection Act of 2006 allows for this combination annuity and long-term care insurance product to have a special tax treatment effective January 1, 2010. After January 1, 2010, any long-term care insurance benefits paid out of such plans are free of taxes even though the payout may represent the deferred taxable growth in the annuity. The law also allows for 1035 exchanges of existing non-combination annuities into these combination plans.

Let's look at two different scenarios. The first, a regular annuity purchased 20 years ago with $100,000 without the long-term care option. The second, a combination LTC annuity purchased with the same amount of money 20 years ago.

Example 1. A 60-year-old purchases a regular annuity for $100,000. Assume over 20 years, the annuity grows to $219,000 at 4% annual growth. This annuity does not have the long-term care rider. At the end of 20 years, the owner cashes out $219,000 and pays $36,000 of taxes based on her federal and state tax rates. She nets $183,000 after tax.

Example 2. Compare example 1 to a policy with a long-term care insurance rider attached that pays out up to 200% of account value, with a cost of .65% per year taken off of the account value every year to cover the cost of the long-term care insurance. The annuity does not grow as large because of the underlying cost of covering the risk of long-term care insurance. It only grows to $193,000 instead of $219,000 over 20 years as in example 1. On the other hand, the value of the policy for long term purposes is double the annuity value or $386,000. If the owner qualifies for the long-term care insurance payout, she will receive $386,000 over a total 48 month payout. Because of the special tax rule this entire amount is free of taxes. Instead of $183,000 after taxes in example 1, she received $386,000 free of taxes from the combo policy in example 2.

Next, consider a second scenario, where the same individual buys a combo policy with six years of long-term care payout. The insurance cost is more due to the larger payout and costs .90% per year of the account value. Over 20 years, the $100,000 purchase only grows to $184,000 at 3.1% instead of 4% interest. But the contract also pays out more. The owner will receive $522,000 tax-free over six years of long-term care payouts.

These particular policies are for individuals who are concerned about the risk of needing long term care. They are not for individuals who are looking for an investment only. Most purchasers of long-term care insurance buy traditional indemnity policies that require paying premiums until they need the policy or until they die. If they don't use the policy, they lose all of their premiums that were paid in. In some cases, this could represent an outlay of $80,000-$100,000 that was never used.

The combo policy provides an alternative. If the long-term care portion is not used, the purchaser at least gets back his or her contribution to buy the policy plus interest. However, compared to an equivalent annuity without the long-term care rider, the value of a combo policy is smaller.

Congress, has provided an additional incentive to encourage people to buy these kinds of policies by forgiving all of the taxes that would be due on buildup inside of the annuity if the annuity is paid out monthly for long term care services. And, as an extra incentive, existing annuities with a taxable inside buildup can be rolled over to one of these combo policies and possibly allow the inside buildup taxes to be forgiven if that value is paid out for use with long term care.

In order to obtain such a policy, the purchaser must go through a medical underwriting process where the insurance company looks at the lifestyle and medical history of the person purchasing the insurance to make sure that the risk of providing the insurance is acceptable. If the purchaser represents an unacceptable risk for needing long term care, the insurance company will either deny the coverage or charge a larger insurance risk premium. For example, the six-year policy above charged a .09% per year risk premium for the insurance. A combination policy that represents a higher risk to the insurance company could charge 1.8% per year or more. The end result with higher risk is that the total payout and the total annuity value are going to be smaller during the growth of the annuity.

The long-term care benefit is triggered two ways.

1. Benefits will be paid out tax-free, if the person who has the coverage cannot perform two of the six activities of daily living (bathing, continence, dressing, eating, transferring, toileting) or

2. is cognitively impaired

We need to ask the question whether this type of annuity and long term care insurance combination is always superior to the long term care insurance that is bought with a monthly or yearly premium and no lump sum cash values?

The first difference is obvious. If there is no lump sum amount to purchase a combo LTC annuity, then the traditional indemnity purchase option is the only one. Most of these combo policies require a minimum purchase amount of $50,000 or up to $100,000 depending on the company.

The second difference is not so obvious. What if John purchases a periodic premium policy that costs him $5,000 a year and pays out $150,000 over 3 years of benefit. What if after 10 years, John needs to use this policy? John's policy includes an automatic inflation rider of 5% a year. After 10 years, due to the inflation rider, John can receive up to $246,000 for a $50,000 investment.

Now let's suppose that John purchases a combo annuity policy for $50,000 that pays out $100,000 over 3 years? After 10 years, the policy has grown to $67,000 and will pay out $134,000 of benefit. In essence, the combo policy cost $67,000 because all of that money is used for the payout. The combo policy cost over twice as much as the periodic premium policy for only half of the benefit.

Which was the better investment if long term care were the objective?

What about after 20 years?

The periodic premium policy after 20 years will pay out a total of $403,000 worth of benefit at a total cost of $100,000.

The combo annuity policy after 20 years will be worth $91,000 and will only pay out a total of $182,000 of long-term care benefit. In essence, the combo policy cost $91,000 because the entire amount will be used to pay out the benefit.

If the intent is to buy only long-term care insurance -- which represents about 60% risk for those 65 and older -- then the combo annuity policy is an extremely poor return on the investment when compared with the periodic premium purchase policy.