1035 Exchange: Annuity to Long-Term Care Insurance

For many individuals planning for retirement, balancing the need for future income with the potential costs of long-term care can be a challenge. One financial strategy that has gained attention is the 1035 exchange from an annuity to long-term care insurance. This IRS-approved provision allows policyholders to transfer funds from an existing annuity directly into a qualified long-term care insurance policy without triggering immediate tax consequences. By leveraging this option, consumers can repurpose assets originally intended for retirement income to help cover the rising expenses associated with extended care needs. 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 possible by a federal law, the Pension Protection Act, that was 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 conditions 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 the average annual premium for a healthy couple both aged 55 was $3,050. As policyholders 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.

Benefits of 1035 Exchanges

One of the primary benefits of 1035 exchanges is the ability to transfer funds from one annuity or life insurance policy to another without triggering an immediate tax liability. This means that any gains accumulated in the original policy can continue to grow tax-deferred in the new contract. By maintaining this tax-advantaged status, investors can maximize the compounding effect on their savings, potentially leading to greater long-term growth.

A 1035 exchange allows policyholders to move their assets into newer or more suitable insurance or annuity products. Over time, insurance companies often introduce policies with improved features, lower fees, or enhanced investment options. By utilizing a 1035 exchange, you can take advantage of these advancements without having to cash out your existing policy and incur taxes on the gains.

Perhaps the most significant advantage of a 1035 exchange is the ability to avoid immediate taxation on any gains in your existing policy. If you were to surrender your policy for cash and then purchase a new one, you would likely owe taxes on any growth. By using a 1035 exchange, you can sidestep this tax event and keep your money working for you.

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 reduce 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 directly 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

Using a 1035 exchange to transition from an annuity to long-term care insurance can be a strategic move for those looking to better align their financial resources with future healthcare needs. This IRS-sanctioned process allows you to transfer the cash value of an existing annuity into a long-term care insurance policy without triggering immediate tax consequences, making it an attractive option for many retirees and pre-retirees. However, it’s essential to carefully evaluate your current annuity’s terms, potential surrender charges, and the suitability of the new long-term care policy before making the switch.

Long-Term Care Tips

A financial advisor can help you evaluate the tax and investing consequences of a 1035 exchange. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel 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.