Using Annuities to Pay for Long-Term Care

Long-term care is one of the largest financial risks facing retirees. A private room in a nursing home now costs more than $131,000 per year on average, and costs continue to climb. Medicare does not cover most long-term care, and Medicaid requires you to spend down nearly all of your assets before it kicks in. Traditional long-term care insurance can help, but premiums have risen sharply and many people are turned down due to health conditions.

Annuities offer several alternative paths to funding long-term care. You can purchase a hybrid annuity-LTC product, execute a tax-free 1035 exchange from an old annuity into LTC coverage, use a Medicaid-compliant annuity to protect assets while qualifying for benefits, or simply use annuity income to pay LTC insurance premiums. Each approach has distinct advantages, limitations, and tax implications. This guide explains how each one works and helps you determine which strategy fits your situation.

Annuity-LTC Hybrid Products

Annuity-LTC hybrids, sometimes called combination products, are deferred annuities that include a built-in long-term care benefit rider. You make a single premium payment, typically ranging from $50,000 to $250,000, and the annuity grows at a fixed interest rate. If you ever need long-term care, the rider provides access to a pool of funds, usually two to three times your initial deposit, that can be used for qualified care expenses.

For example, if you deposit $100,000 into a hybrid annuity with a 3x LTC multiplier, you would have up to $300,000 available for qualified long-term care expenses. The benefit is typically paid out as a monthly maximum over a defined period, such as $5,000 per month for 60 months. The exact terms vary by insurer and product.

One of the biggest selling points of hybrid products is that your money is never wasted. If you need care, the LTC rider pays for it. If you never need care, your beneficiaries receive the accumulated annuity value as a death benefit. This addresses a major objection to traditional LTC insurance, where premiums are lost entirely if you never file a claim.

Under the Pension Protection Act of 2006 (PPA), LTC benefits paid from a qualifying annuity-LTC hybrid are generally received tax-free, provided the benefits are used for qualified long-term care services. This is a significant tax advantage compared to withdrawing from a standard annuity, where gains are taxed as ordinary income. The PPA provision makes hybrid products especially attractive for people with existing annuities that have large taxable gains.

1035 Exchange: Tax-Free Annuity-to-LTC Transfer

If you already own an annuity that you no longer need for retirement income, a 1035 exchange allows you to transfer its value into a qualifying long-term care insurance policy or hybrid annuity-LTC product without triggering any income tax. Under IRS Section 1035, this is treated as a tax-free exchange rather than a taxable withdrawal followed by a new purchase.

Before the Pension Protection Act of 2006, exchanging an annuity for a standalone LTC policy was not explicitly permitted as a 1035 exchange. The PPA clarified that annuity-to-LTC exchanges qualify for tax-free treatment, opening the door for millions of annuity holders to repurpose old contracts into care coverage. This provision took effect on January 1, 2010.

A 1035 exchange is especially valuable if your existing annuity has large unrealized gains. For example, if you purchased an annuity for $75,000 and it has grown to $120,000, a direct withdrawal would trigger income tax on the $45,000 gain. A 1035 exchange lets you move the full $120,000 into an LTC product or hybrid annuity without any immediate tax liability.

To execute a 1035 exchange properly, the transfer must go directly from the old insurance company to the new one. You should never take possession of the funds yourself, as that would convert it into a taxable event. Work with your insurance agent and the receiving company to ensure the paperwork is handled correctly. Consult a tax professional to confirm the exchange qualifies under IRS rules.

Medicaid-Compliant Annuities

Medicaid is the primary payer of long-term care in the United States, but it is a means-tested program. To qualify, individuals typically must have countable assets below $2,000, though the non-applicant spouse (called the community spouse) may retain additional assets within limits that vary by state. This spend-down requirement forces many couples to deplete their life savings before Medicaid begins covering care.

A Medicaid-compliant annuity is a single premium immediate annuity (SPIA) specifically designed to convert countable assets into a stream of income. When structured correctly, the annuity itself is not counted as an asset for Medicaid eligibility purposes because it is irrevocable and cannot be cashed out. Instead, the monthly payments are treated as income, which can be used to pay for the community spouse's living expenses.

To be Medicaid-compliant, the annuity must meet several requirements. It must be irrevocable and non-transferable. It must be actuarially sound, meaning the payout period cannot exceed the annuitant's life expectancy. It must provide equal payments with no deferral or balloon features. And it must name the state Medicaid agency as the primary beneficiary, or the secondary beneficiary after the community spouse, up to the total amount of Medicaid benefits paid on behalf of the institutionalized spouse.

Medicaid-compliant annuities are most commonly used to protect assets for the community spouse when one spouse enters a nursing home. For instance, if a couple has $200,000 in excess countable assets, the community spouse could purchase a Medicaid-compliant annuity with those funds, converting the assets into monthly income and potentially allowing the ill spouse to qualify for Medicaid immediately rather than spending down the savings. Medicaid rules are complex and vary by state, so you should consult a financial advisor or elder law attorney before taking this step.

Using Annuity Income to Pay LTC Premiums

A simpler approach is to use income from an existing annuity to pay premiums on a standalone long-term care insurance policy. If you own a deferred annuity with a substantial balance, you can set up systematic withdrawals or annuitize the contract to generate regular income, then direct that income toward LTC premiums.

This approach keeps the annuity and LTC policy as separate products, giving you more flexibility. You can choose any standalone LTC insurer and policy design, and you retain the ability to change your premium payment strategy if your needs evolve. If you stop needing the LTC coverage, you can redirect the annuity income elsewhere.

The downside is that annuity withdrawals are taxable to the extent they include gains (using LIFO accounting), so you would owe income tax on the withdrawn amounts before using them to pay premiums. This is less tax-efficient than a 1035 exchange, which avoids taxation entirely. However, if your annuity's cost basis is high relative to its current value (meaning there are minimal gains), the tax impact may be small.

Another consideration is that LTC insurance premiums may be tax-deductible if you itemize deductions and the premiums exceed 7.5% of your adjusted gross income. The deductible amount depends on your age and is subject to IRS limits. This partial deduction can offset some of the tax you pay on the annuity withdrawals. Consult a tax professional to evaluate the net tax impact.

Pension Protection Act of 2006: Key Provisions

The Pension Protection Act of 2006 (PPA) is the landmark legislation that made annuity-based LTC planning significantly more attractive. Two provisions are especially important. First, the PPA allowed tax-free 1035 exchanges from annuities to qualified long-term care insurance contracts, effective January 1, 2010. Before this change, such exchanges were in a legal gray area.

Second, the PPA established that benefits paid from qualifying annuity-LTC combination products for qualified long-term care services are excluded from gross income. In plain terms, this means the LTC benefits you receive from a hybrid annuity-LTC product are tax-free, similar to benefits paid from a standalone tax-qualified LTC insurance policy.

These two provisions together created a powerful planning opportunity. An annuity holder with a contract full of taxable gains can exchange it into a hybrid product, avoid the tax on the gains, and later receive LTC benefits tax-free. Without the PPA, the same person would face a large tax bill on the exchange or withdrawal, reducing the amount available for care.

Pros and Cons of Each Approach

Annuity-LTC hybrid products offer the most comprehensive solution. The pros include tax-free LTC benefits, a death benefit if you never need care, and no risk of losing premiums. The cons are that hybrids require a large upfront lump sum, the LTC benefit may be smaller than what a standalone policy would provide for the same cost, and the annuity growth rate is typically lower than a standard MYGA because part of the premium pays for the LTC rider.

A 1035 exchange is best if you already own an annuity with significant gains that you want to repurpose. The major advantage is tax-free transfer. The downside is that you lose access to the original annuity's accumulation value, and the receiving product must qualify under IRS rules, which limits your options. Not all LTC policies accept 1035 exchanges, so availability can be a constraint.

Medicaid-compliant annuities serve a very specific purpose: protecting assets for the community spouse when the other spouse needs nursing home care. They are not a general planning tool and are only useful in the context of Medicaid qualification. The major risk is that Medicaid rules change frequently, and what is compliant today may not be compliant tomorrow. An elder law attorney should always be involved in this planning.

Using annuity income to pay LTC premiums is the simplest approach but the least tax-efficient. It works well when your annuity has minimal gains, when you want to keep the annuity and LTC policy separate for flexibility, or when you cannot find a suitable hybrid product or 1035 exchange option.

The right approach depends on your existing assets, health status, family situation, and long-term care goals. In many cases, a combination of strategies works best. For example, you might execute a 1035 exchange for a portion of an old annuity into a hybrid product while keeping the rest of the annuity intact for retirement income.

Long-term care planning is one of the most important and often overlooked parts of retirement preparation. With nursing home costs exceeding $131,000 per year and the average care need lasting roughly three years, the financial exposure can easily reach $200,000 to $400,000 or more. Annuity-based strategies provide several powerful tools for managing this risk, from tax-free hybrid benefits to Medicaid asset protection. Consult a financial advisor who specializes in retirement and long-term care planning to build a strategy that protects both your health and your savings.