It’s a fact that many of us will need expensive long-term care at some point in our lifetimes, either in our homes or health care facility. While wealthy households may opt to pay for such care out of pocket, there are other options.
Consider a 1035 Exchange
One strategy, which involves an attractive tax benefit, is known as a tax-free 1035 exchange. It allows you to replace an existing annuity or life insurance policy with a new one that provides a long-term care (LTC) benefit. In the right situation, 1035 exchanges can be an effective tool within your long-term wealth plan. By the way, if 1035 exchanges sound familiar, it may be because they’re similar in concept to 1031 exchanges. The latter allow for the sale of real estate without a capital gains tax bill if the sale proceeds are used to purchase a similar type of property.
Understand the Cost of Long-Term Healthcare
An individual turning age 65 today has a 70% chance of needing some type of LTC over the course of their lifetime, and one in five will need such care for more than five years.1 Whether the reason is cognitive or physical impairment, the cost of care can be steep. The average annual bill for a private room in a nursing home is $108,404, but you may want more than an average level of care.2 Keep in mind that few, if any, LTC-related costs are covered by Medicare.
Remember as well that LTC costs sit on top of the growing cost of routine health care in retirement. Fidelity Investments estimates that a typical 65-year-old couple retiring today will need $315,000 for medical expenses over the course of their lifetime. The estimate assumes both spouses are enrolled in traditional Medicare, and Medicare Part D, and thus have a wide range of expenses already covered.3
The Case Against Paying Out of Pocket
High-net-worth households may be able to comfortably cover all these costs from savings, investment proceeds or other means. But using a 1035 exchange to access LTC benefits may still be worth exploring. Unexpected health crises have prompted many a household to dip into investments during market downturns. Insurance solutions, such as riders connected to permanent life policies or annuities, can help ensure that won’t be necessary. That’s one example of where a 1035 exchange might make sense.
A 1035 exchange may hold extra appeal for those who want to switch from their current life insurance policy or annuity. The reason might be financial uncertainty surrounding the current product provider, economic or health changes on the part of the policy owner or new goals related to estate planning or business succession. Your wealth team can help you spot such opportunities.
How 1035 Exchanges Work
The strategy allows those who own an life insurance policy or annuity to covert it into a new one that is “of like kind.” As long as IRS requirements are met—for example, the new policy must have the same owner, insured or annuitant as the old policy or annuity—then the exchange won’t trigger tax on any gains from the original policy. Thus, a variable annuity that had delivered substantial gains might be converted, tax free, to an annuity that features a long-term-care benefit. A 1035 exchange, in fact, is the only way gains from an annuity can currently be tapped for long-term care expenses without triggering a tax bill.
Avoiding Tax Triggers
It’s important to note that 1035 exchanges require a direct exchange between insurance companies. In other words, individuals who cash out a life insurance policy or annuity and use the proceeds to buy another one will forfeit their tax break.4 Note too that, depending on the terms of your older insurance or annuity contract, an exchange may trigger a surrender charge.
Understanding Insurance Options
Some life insurance policies allow the addition of a rider providing coverage for long-term care. Typically, a portion of the life insurance policy’s death benefit is used to pay for long-term care needs. Any remaining balance of the death benefit is distributed to beneficiaries. Deferred annuities, which can provide an income stream starting at a specified date, are also available with LTC riders. Payments to cover long-term care become available once the recipient meets specific medical criteria, such as diagnosis of a chronic or terminal illness that requires round-the-clock care.
Simplifying a Complex Decision
There’s no one-size-fits-all solution to funding long-term care. The best strategy for you depends on your unique situation, including your age and health and long-term goals. Your wealth team can walk you through your options, and help you determine whether the strategic use of a life insurance policy or annuity to pay for LTC makes sense for you.
Footnotes
1“How Much Care Will You Need?”
2“How to Pay for Nursing Home Costs”
3“Fidelity Releases 2022 Retiree Health Care Cost Estimate”
4“What Is a 1035 Exchange? Definition and How the Rules Work”
This article is being provided for informational and educational purposes only and does not consider any individual personal, financial, legal, or tax considerations. The information contained herein is not intended to be personal legal, investment, or tax advice or a solicitation to engage in a particular strategy. Please consult a qualified professional regarding your personal situation prior to making any financial, legal, or tax-related decisions.
Before initiating a 1035 exchange, there are important factors to consider which could reduce or eliminate the benefit of the exchange. These include surrender charges on the existing contract, loss of guaranteed benefits, and differences in features, costs, services, and company strength.
All guarantees and benefits of the insurance policy are subject to the claims-paying ability of the issuing insurance company.
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