LTC/Combo Products on Life Insurance and Annuities- Understanding the Current Tax Laws and Defining Sales Opportunities

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1 LTC/Combo Products on Life Insurance and Annuities- Understanding the Current Tax Laws and Defining Sales Opportunities Shawn Britt, CLU Director, Long-term Care Initiatives Advanced Consulting Group Nationwide Financial Columbus, Ohio When it comes to purchasing long-term care (LTC) coverage, there are a lot of options available to the consumer today. However, one thing is clear people need a plan. Those still living at the age 65, have a 70 percent chance of needing some type of long-term care service in their lifetime 1. Consider as well that the person more likely to need that care is female as they comprise 66% of all LTC claims 2. But men also need to plan for LTC, in part because caregivers are likely to die before the loved one they are caring for 3. LTC coverage helps preserve financial assets for the surviving spouse as well as provides funds that can be used to obtain additional help the care giving spouse with care duties. That help may make a difference in maintaining the health and longevity of the caregiver. These statistics show there is a need for LTC protection, but it s also important to position your client with a product that best suits their overall financial strategy, and their ability and willingness to purchase protection. New 1035 Exchange Rules Tax rules changed starting Jan. 1, 2010, allowing cash values from life insurance, endowment, and annuity contracts to be transferred through a 1035 exchange to stand alone long-term care policy without paying tax on the contract gains. This is a plus for people who have such contracts they no longer find valuable to their financial strategy and now desire coverage from a traditional long-term care plan. This also makes annuity and life insurance contracts with LTC riders more flexible to an overall lifetime strategy. When purchasing such products, the client will have more flexibility should their future strategy change and a full bells and whistles long term care contract be desired. The life or annuity contract, no longer needed, will be able to supply funding for the traditional LTC policy without taxable consequences. In the meantime, adding a LTC rider to the life insurance or annuity purchase, puts something in place should the client become uninsurable in the future for a standard LTC policy.

2 Tax law changes creates market for new LTC/Combo products Life Insurance and annuities have offered LTC riders for a while now, but with the tax law changes provided by the Pension Protection Act 2006 that went into effect Jan. 1, 2010, new products are emerging as more companies see value in this linked offering. When the client is younger, it can be difficult to have a discussion on long-term care planning. However, when planning for future retirement needs with annuities, or family protection through life insurance, adding a long-term rider may make sense for a younger client as an inexpensive beginning to LTC planning. Old Law vs. New Law for Life Insurance/LTC Combos Under the old law, the LTC benefit on life insurance/ltc riders was tax-free. However, past law dictated that when a contract was a MEC (modified endowment contract) and had gains in the contract, the cost of the rider would be considered a distribution and taxed as ordinary income. However the cost of rider was able to be deducted as a medical expense if the contract owner had met the then 7½% floor. On a non-mec contract, the cost basis was reduced by the cost of the rider. As long as there was cost basis, there would be no taxable event. But once cost basis was exhausted, the cost of the rider was treated as a taxable distribution. The most common reason for cost basis to be exhausted would be a contract in which the owner has taken withdrawals to basis. The cost of the rider was not deductible as a medical expense on a non-mec contract. Under the new law, the LTC benefit continues to be tax free. The amount that may be collected tax free, cumulative of all contracts owned, remains the same as before which is the greater of the HIPAA per diem rate (for 2015, $330 per day or $9,900 in a 30 day month) or actual long-term care costs incurred. In addition the cost of the rider is no longer treated as a taxable distribution on a MEC contract. However, you will not be able to deduct the cost of the rider as a health expense. No deduction as a medical expense is allowed for any payment made for long-term care coverage if the payment is made from the cash value from an annuity or life insurance contract. The cost basis on a non- MEC contract will continue to be reduced, but can never go below $0, and should it be exhausted, the rider cost will not be treated as a taxable distribution. Old Law vs. New Law for Annuity/LTC Combos Prior to the tax law changes, LTC benefits paid from an annuity with a LTC rider were taxable as ordinary income. While this combo had its benefits, it was not always seen by the consumer as advantageous in comparison to other LTC offerings with tax-free LTC benefits. Under the new law, LTC benefits paid from a rider on an annuity contract may be paid income taxfree. (Keep in mind the rider attached to the annuity contract must meet the IRS standards for tax free LTC benefits, so you will need to consult the contract to verify the tax qualification status of the rider.) The cost of the rider is no longer being treated as a distribution therefore - is not taxable to the contract owner. However, cost basis in the contract will be reduced by the cost of the LTC rider, though it will never go below $0. This can affect how actual income from the contract would be taxed, since the lowering of the cost basis will lower the exclusion ratio on annuitization, or create a larger amount of gain to be taxed if taking withdrawals, causing a higher percentage of the income stream to be taxable. Also, the cost of the LTC rider may not be taken as a deduction for medical expenses.

3 When evaluating the purchase of a variable annuity, your clients should be aware that variable annuities are long-term investment vehicles designed for retirement purposes and will fluctuate in value; annuities have limitations; and investing involves market risk, including possible loss of principal. The Proper Fit - Annuity/LTC sale vs. Life/LTC sale? Where do combo products in general fit into the picture? Common to both type products is that they may be a palatable solution for clients who have resisted purchasing a standard LTC contract. Typical reasons for objecting to these contracts are the use it or lose it (loss of premium) factor and fear of the LTC industry (such as rate hikes). Combo products may be more acceptable to the consumer, because a benefit is paid to the contract owner* whether long-term care is needed or not. But there are more reasons that define positioning of these products. As you understand when and where these combo solutions are ideally used, you ll find the annuity and the life insurance combo sales are noncompeting. The Annuity/LTC Combo Adding an LTC rider to an annuity supplies an additional component to the income strategy. The additional cost for the LTC rider is generally the same regardless of the client s age when the contract is purchased. The cost comes in the form of additional basis points charged to the contract which results in a lower net rate of return on the annuity contract. The ideal prospect for an annuity/ltc combo is someone who does not have sleeping assets or disposable income not needed for retirement. They may find the expenditure of a standard LTC product cost-prohibitive when they believe they may need every dollar they have for retirement needs. This client has a fear of running out of income whether from living too long or having to pay the high cost of long-term care. The annuity/ltc combo may provide a solution that meets with this client s comfort level. For an additional fee, a rider is added that allows a LTC benefit - paid tax-free if the rider is tax qualified under 7702B (or equivalent) - to be paid in lieu of taxable income. Either way, they are assured of an income stream. In addition, some annuity products with a LTC rider do not require underwriting, providing a potential solution for people otherwise uninsurable for LTC coverage. Inflation features are not offered with this type coverage. But that is where the similarity ends. It s important that financial professionals understand the product they are selling as annuity/ltc combo contracts vary greatly between companies. The majority of annuity combos currently exist on fixed contracts, though some variable annuity offerings exist as well. Many companies have an exclusion period in addition to an elimination period (some companies will allow these to run concurrently). The exclusion period is a time period, beginning at contract issue, usually between two and seven years, where LTC benefits are not available. The elimination period is different, and starts when the client qualifies for long-term care. At the end of the elimination period, usually 90 days, LTC benefits will begin to be paid. It is also important to note that some annuity companies drop the LTC rider when lifetime income begins making it an eitheror solution.

4 The Life Insurance/LTC Combo** Adding a LTC rider to a life insurance policy will allow for the death benefit to be collected by the contract owner to pay for long-term care needs of the insured***. The charge for the LTC rider on a life insurance policy varies by company and may be based on age and net amount at risk, or a level charge determined by age at issue. Either way, the additional cost for the rider is very inexpensive at younger ages, so it might make sense to add regardless of the insured s age. The typical prospect for a life insurance/ltc combo can take two forms. One type life/ltc prospect is a client with retirement funding set in place that has excess assets they wish to use to create a tax efficient legacy. They also have long-term care concerns and often have the typical objections to stand alone long-term care policies. With the life/combo product, the death benefit can be used, while the insured is alive to help pay for LTC expenses. If LTC is never needed, the death benefit goes federal income tax free to the beneficiary (estate tax free as well with proper estate planning). The other potential life/ltc prospect comes from younger clients not ready to discuss purchasing a full stand alone LTC policy. It puts something in place, at a potentially low annual cost, should the client not qualify for long-term care in the future. The benefit on a life/ltc combo is generally paid after an elimination period (0 to 90 days is typical). Exclusion periods generally do not apply to these products, so the insured could in fact file a claim on these contracts immediately after issue should an unexpected LTC need arise. The benefit is normally paid monthly and is a percentage of the LTC rider specified amount, such as 2% per month of the total specified amount. A minimum death benefit guarantee often is included, which allows the insured to go through the entire LTC amount, but still leave a death benefit - generally 10% of the original specified amount to the beneficiary. Please note that LTC Riders on life insurance are underwritten separately; therefore it is possible to qualify for the base insurance policy, but for the LTC rider to be declined. Some companies will allow LTC riders to be rated, which may increase the premium that was originally illustrated. Inflation features are not offered on Long-term Care riders. Qualifying for Claim LTC stand alone policies and LTC/combo contracts that are tax qualified (paying tax-free LTC benefits) do have certain things in common. The LTC claim is triggered when a licensed health care practitioner certifies the insured is either unable to perform two out of six activities of daily living for at least 90 days, or, has severe cognitive impairment. A plan of care is also required at time of claim. In addition, annual re-certification of the claim is generally required. Some insurance companies will pay for the annual re-certification while other will require that the policy owner pay. Care generally is required to be given by a licensed facility or employee of a licensed service (unless a pure cash plan), though some plans will allow informal caregivers. Keep in mind that immediate family members may be excluded as allowable caregivers, even if they are professionally qualified, so please consult the issuing company s contract for more detail.

5 Indemnity vs. Reimbursement It s important to educate a client on how the product they re purchasing will work for them. Regardless of whether they are purchasing a stand alone policy or product with a long-term care rider, the client should understand the options for payout of benefits. Most contracts pay benefits by one of the following methods - either by indemnity or reimbursement. A reimbursement contact will pay up to the maximum benefit amount, but no more than the actual cost of qualifying care expenses incurred each month. Bills and receipts generally need to be submitted to the insurance company each month to receive a payout. The benefit may be paid directly to the facility or service providing care, or reimburse the policy owner directly for costs already incurred. Reimbursement policies often coordinate benefits, so regardless of how many reimbursement contracts are owned, the companies will share on a pro-rata basis the benefit amount paid out, assuring the policy owner does not receive more than their actual cost of care expenses. An indemnity contract works quite differently, paying the full qualifying benefit directly to the policy owner, regardless of what the expenses are. There are generally two types of indemnity-type benefits with LTC riders: 1. There are some policies that do not require monthly submission of bills or receipts while on claim to receive monthly LTC benefits. With this type policy, once all qualifiers for LTC benefits are met, a check for full LTC benefits is sent each month to the owner of the policy*** without any consideration to cost of care. 2. There are other policies that require monthly proof of billable services in order to obtain benefits. With type policy, once all qualifiers have been met, the full benefit amount will be paid regardless of what the billed amount is, however, there must be a billed service in order to qualify for receiving benefit payments. People who have purchased pre-paid assisted living packages in Continuous Care Retirement Communities (CCRCs) may find a policy of this type will not pay benefits for their assisted living claim since there are no bills to submit. Please consult the policy contract for specific details from the issuing company. With indemnity plans, there is no coordination of benefits, so it is possible to collect full benefits from multiple contracts. Keep in mind however that the most that can be collected tax free is the greater of the HIPAA per diem amount for the given year of claim ($330 per day in 2015), or actual LTC expenses incurred. Amounts collected in excess of the IRS formula will be taxed as ordinary income. Conclusion Today s product choices for your clients offer a variety of solutions, whether they desire traditional long-term care, a life insurance/ltc combo that offers asset transfer possibilities with LTC protection, or an annuity/ltc combo that may provide a lifetime income options for retirement with LTC options. Regardless, the choices are many, and may offer a LTC solution that is agreeable to your client s goals and budget.

6 1 Wall Street Journal Marketwatch The Cost of Long-term Care in your State, Anne Tergensen, April 15, American Association for Long term Care Insurance (AALTCI) 2014 SourceBook 3 Ron Kauffman, I m Losing Myself Being a Caregiver, Caring.com Feb *This discussion applies only to Long-term Care Riders and does not refer to Chronic Illness riders **While less common, keep in mind there are contracts that pay LTC benefits to the insured, even when the contract is owned by another party. Please thoroughly review the contract in the state of issue you are considering for details of whom benefits will be paid to. *** Keep in mind when the owner is someone other than the insured, and benefits are paid to the contract owner, there is no guarantee the LTC expenses of the insured will be paid. The following information was created to support the general promotion of life insurance, annuities, and/or other products and services from Nationwide Life Insurance Company, which are described within. Neither Nationwide nor any of its employees provide tax or legal advice. For answers to your specific questions, you should consult with your legal and tax advisors to see how the information may apply to your personal situation. This information is not intended to be used and cannot be used to avoid penalties under the Internal Revenue Code. This information assumes that the life insurance is not a modified endowment contract, or MEC. As long as the contract meets the non-mec definitions of IRC Section 7702A, most distributions are taxed on a first-in/first-out basis. Surrender charges may apply to partial surrenders. Loans and partial surrenders from a MEC will generally be taxable, and if takenprior to age 59½, may be subject to a 10% tax penalty. Loans and partial surrenders will reduce the cash value and the death benefits payable to the named beneficiary(ies), and withdrawals above the available free amount will incursurrender charges. If your contract were to lapse with a loan outstanding, the loan amount in excess of basis will be treated as a distribution and all or a portion will be subject to income tax. Riders are offered at an additional cost and may not be available in all states. A life insurance or annuity purchase should be based on the life insurance or annuity contract, and not optional riders or features. The cost of an option may exceed the actual benefit paid under the option.keep in mind that as an acceleration of the death benefit, the LTC rider payout will reduce both the death benefit and cash surrender values. Care should be taken to make sure that your clients' life insurance needs continue to be met even if the rider pays out in full. There is no guarantee that the rider will cover the entire cost for all of the insured's long-term care as these vary with the needs of each insured. As your clients' personal situations change (i.e., marriage, birth of a child or job promotion), so will their life insurance needs. Care should be taken to ensure these strategies and products are suitable for long-term life insurance needs. You should weigh your clients' objectives, time horizon and risk tolerance as well as any associated costs before investing. Also, be aware that market volatility can lead to the possibility of the need for additional premium in the policy. Variable life insurance has fees and charges associated with it that include costs of insurance that vary with such characteristics of the insured as gender, health and age, underlying fund charges and expenses, and additional charges for riders that customize a policy to fit your clients' individual needs. Life insurance and annuities are issued by Nationwide Life Insurance Company or Nationwide Life and Annuity Insurance Company, Columbus, Ohio. The general distributor for variable insurance products is Nationwide Investment Services Corporation, member FINRA. NFM-7283AO.4

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