Can You Exchange an Annuity for LTC Insurance? The 1035 Option

Long-term care is one of the biggest financial risks facing Americans over age 65. According to government estimates, about 70 percent of people who reach age 65 will need some form of long-term care during their lifetime. The costs can be staggering, with nursing home care averaging well over $90,000 per year in many states. Yet many people reach retirement without any plan to pay for this care.

If you own an annuity that you no longer need for retirement income, there is a little-known tax strategy that could solve two problems at once. Under IRS Section 1035, as expanded by the Pension Protection Act of 2006, you can exchange an annuity directly into a qualified long-term care insurance policy without paying a single dollar in taxes. This is called a 1035 exchange, and it allows you to reposition an underperforming or unneeded annuity into LTC coverage that could protect your savings and your family.

In this article, we will explain how the 1035 exchange from annuity to LTC insurance works, who it is best for, what the IRS rules require, and what you need to know before making the switch. If you have been sitting on an old annuity and wondering whether it still makes sense for your situation, this strategy might be exactly what you need.

What Is a 1035 Exchange?

Section 1035 of the Internal Revenue Code allows you to exchange one insurance or annuity contract for another without triggering a taxable event. Originally, the law covered exchanges between like-kind contracts: life insurance for life insurance, annuity for annuity, and life insurance for annuity. The logic was simple. If you are not cashing out and simply replacing one policy with another, you should not have to pay taxes on the exchange because no money came into your pocket.

In 2006, Congress passed the Pension Protection Act (PPA), which expanded Section 1035 to include a new type of exchange. Starting January 1, 2010, you could exchange an annuity or a life insurance policy directly into a tax-qualified long-term care insurance contract, and the exchange would be completely tax-free. This was a major development because it gave people with old, low-performing annuities a practical way to convert those assets into valuable LTC protection.

Why Would You Exchange an Annuity for LTC Insurance?

There are several common situations where exchanging an annuity for LTC insurance makes good financial sense. Understanding these scenarios can help you decide if this strategy is right for you.

You Own an Annuity You No Longer Need

Maybe you bought an annuity years ago as part of a retirement savings plan, but your circumstances have changed. Perhaps you now have a pension, Social Security provides more than you expected, or you have other savings that cover your income needs. If the annuity is just sitting there accumulating gains you do not need, it could be a perfect candidate for a 1035 exchange into LTC insurance. Instead of letting it collect dust, you put it to work protecting you against one of the biggest financial risks of aging.

Your Annuity Has Large Taxable Gains

If your annuity has grown significantly over the years, cashing it out would trigger a hefty income tax bill on all of the gains. For example, if you invested $50,000 and the annuity is now worth $90,000, you would owe income tax on the $40,000 in gains if you surrendered the contract. With a 1035 exchange, you transfer the full $90,000 into an LTC policy without paying any tax. The tax basis carries over to the new contract. And if the LTC benefits are used for qualified long-term care expenses, those payouts may also be tax-free, meaning you could potentially avoid paying tax on those gains entirely.

You Cannot Afford LTC Premiums Out of Pocket

Long-term care insurance premiums can be expensive, especially if you are in your sixties or older. A single premium or limited-pay LTC policy funded through a 1035 exchange lets you use money that is already set aside (in your annuity) to buy coverage without any impact on your monthly budget. You are essentially converting one asset into another, rather than writing new checks from your bank account.

You Want to Protect Your Retirement Savings from LTC Costs

Without LTC insurance, a long-term care event could drain your retirement savings in just a few years. A nursing home stay that costs $100,000 per year can consume a $500,000 portfolio in five years. By exchanging an annuity worth $80,000 or $100,000 into an LTC policy, you might secure $200,000 to $400,000 or more in LTC benefits, depending on the policy. That leverage is the entire point of insurance: you pay a smaller amount to protect against a much larger potential loss.

IRS Rules for a 1035 Exchange to LTC Insurance

The IRS has specific rules that must be followed for a 1035 exchange from an annuity to long-term care insurance to qualify as tax-free. Understanding these rules is critical because a mistake could turn your tax-free exchange into a fully taxable event.

1. The transfer must be direct. The funds must go directly from the annuity company to the LTC insurance company. You cannot receive the money first and then send it to the LTC insurer. If the check is made out to you, the IRS will treat it as a taxable surrender, not a 1035 exchange.
2. The contract owner must be the same. The person who owns the annuity must also be the owner of the new LTC policy. You cannot exchange your annuity into an LTC policy that your spouse or child owns. The insured person can be different from the owner in some cases, but the ownership must match.
3. The LTC policy must be tax-qualified. Not all long-term care policies qualify. The receiving policy must meet the definition of a qualified long-term care insurance contract under IRC Section 7702B. Most standalone LTC policies sold today meet this standard, but you should verify with the insurer before completing the exchange.
4. The annuity must be a non-qualified annuity (in most cases). Section 1035 applies to annuities held outside of qualified retirement accounts. If your annuity is inside an IRA or 401(k), the exchange rules are different and more restrictive. Consult a tax professional if your annuity is held in a qualified account.
5. Proper paperwork must be completed. Both the annuity company and the LTC insurance company must process the exchange using the correct 1035 exchange forms. Your insurance agent or financial advisor typically handles this paperwork for you, but it is your responsibility to make sure it is done correctly.

Step-by-Step: How to Complete a 1035 Exchange to LTC Insurance

The process of completing a 1035 exchange from an annuity to an LTC policy involves several steps. Here is what to expect.

1. Review your current annuity. Check the current value, surrender charges, any outstanding loans, and the amount of taxable gains. This information will help you and your agent determine whether the exchange makes financial sense.
2. Apply for the LTC policy. You will need to go through the underwriting process for the long-term care policy, which includes health questions and possibly a medical exam or phone interview. Get approved for the LTC policy before initiating the exchange.
3. Complete the 1035 exchange paperwork. Your agent will prepare the exchange forms for both the annuity company (releasing the funds) and the LTC company (receiving the funds). Make sure the forms clearly indicate that this is a 1035 exchange.
4. Wait for the transfer to complete. The annuity company will process the surrender (minus any applicable surrender charges) and send the funds directly to the LTC insurance company. This typically takes two to six weeks.
5. Confirm your LTC policy is active. Once the LTC insurer receives the funds, your policy will be issued and your coverage begins. Keep all documentation related to the exchange for your tax records.

Tax Benefits of the Annuity-to-LTC Exchange

The tax advantages of a 1035 exchange from annuity to LTC insurance are significant and can be the primary reason to pursue this strategy. Let us break down the tax benefits.

• No immediate tax on the exchange. When you surrender an annuity for cash, you owe income tax on all gains. With a 1035 exchange, the entire value transfers tax-free. If your annuity has $40,000 in gains, you save thousands of dollars in taxes by doing the exchange instead of a cash surrender.
• Tax-free LTC benefits. When you receive benefits from a tax-qualified LTC policy to pay for qualifying long-term care expenses, those benefits are generally received income tax-free (up to per diem limits set by the IRS). This means the gains that were inside your annuity could effectively pass through to pay for care without ever being taxed.
• Potential premium deductibility. In some cases, a portion of the LTC insurance premiums paid through the exchange may be deductible as a medical expense on your tax return if you itemize deductions and your total medical expenses exceed the IRS threshold. The deductible amount depends on your age and is subject to annual limits published by the IRS.

Types of LTC Policies You Can Exchange Into

When you do a 1035 exchange from an annuity, you have several options for the type of LTC policy you receive. Each has its own advantages.

Traditional Standalone LTC Insurance

A traditional LTC policy pays benefits when you cannot perform two or more activities of daily living (such as bathing, dressing, or eating) or when you have a cognitive impairment. These policies typically provide a daily or monthly benefit amount for a specified period, such as three, five, or six years. You can fund a traditional LTC policy with a single premium from your annuity exchange, which means no ongoing monthly premiums to worry about.

Hybrid Life Insurance with LTC Rider

Some people prefer hybrid policies that combine life insurance with long-term care benefits. With a hybrid policy, if you need long-term care, the policy pays LTC benefits. If you never need care, the policy pays a death benefit to your beneficiaries. Not all hybrid policies qualify for a 1035 exchange from an annuity, but many do if they include a tax-qualified LTC component. Ask your agent to confirm the policy meets the requirements of IRC Section 7702B.

Annuity with LTC Rider

Another option is to exchange your existing annuity for a new annuity that includes an LTC rider. This type of product keeps your money in an annuity structure but adds long-term care benefits that kick in if you need care. If you never need LTC, the annuity value passes to your beneficiaries. This approach may appeal to people who want to keep the annuity framework but add LTC protection. However, the LTC benefits in these combination products are sometimes less robust than a standalone LTC policy.

Important Considerations Before You Exchange

Before you move forward with a 1035 exchange from an annuity to LTC insurance, there are several factors you should carefully evaluate.

• Your health status. Long-term care insurance requires medical underwriting. If you have significant health issues, you may not qualify for coverage, or you may receive a reduced benefit. Apply for and get approved for the LTC policy before surrendering your annuity.
• Surrender charges on your annuity. If your annuity is still in the surrender period, you will lose a percentage of the value to surrender charges. This reduces the amount available to fund your LTC policy. Check your annuity contract to see if you are past the surrender period or if the charges have decreased to a manageable level.
• Whether you still need the annuity income. If you are relying on your annuity for retirement income, exchanging it for LTC insurance could create a gap in your budget. Only exchange money you can truly afford to redirect. You can also do a partial exchange, keeping some of the annuity intact while moving the rest into LTC coverage.
• The strength of the LTC insurer. Make sure the long-term care insurance company you choose has strong financial ratings. You may not need the LTC benefits for 10 or 20 years, so you want to be confident the company will be around to pay claims when the time comes. Look for insurers rated A or better by AM Best.

Real-World Example: Exchanging an Annuity for LTC Coverage

Here is an example to show how the strategy works in practice. Robert is 64 years old and owns a non-qualified fixed annuity worth $85,000. He originally invested $55,000, so the annuity contains $30,000 in tax-deferred gains. Robert has a pension and Social Security that cover his monthly expenses. He does not need the annuity for income, but he is concerned about long-term care costs.

If Robert cashed out the annuity, he would owe income tax on the $30,000 in gains. At a 22 percent federal tax rate, that would be $6,600 in federal taxes alone, plus any state income tax. Instead, Robert works with a licensed agent to complete a 1035 exchange into a single-premium long-term care insurance policy.

The annuity company transfers the full $85,000 directly to the LTC insurer. Robert pays zero taxes on the exchange. The LTC policy provides $250,000 in lifetime long-term care benefits, with a monthly benefit of approximately $5,500 for up to four years. Robert has turned an underused financial asset into protection against one of his biggest retirement risks, all without paying a penny in taxes.

How This Strategy Compares to Other LTC Funding Options

A 1035 exchange is just one way to fund long-term care insurance. Here is how it compares to the alternatives.

• Paying premiums out of pocket. This is the most straightforward approach, but it requires ongoing premium payments that can strain a fixed retirement budget. A 1035 exchange lets you pay with assets you already have.
• Self-insuring with savings. Some people plan to pay for long-term care out of their investment portfolio. This can work if you have substantial assets, but it puts your entire nest egg at risk. An LTC policy provides leverage, turning $85,000 into $250,000 or more in coverage.
• Relying on Medicaid. Medicaid covers long-term care, but only after you have spent down nearly all of your assets. For most people, this means losing their life savings before qualifying. A 1035 exchange into LTC insurance helps you preserve your assets and maintain control over your care choices.

Talk to a Licensed Agent About Your Options

A 1035 exchange from an annuity to long-term care insurance is a powerful strategy, but it requires careful planning and the right guidance. The IRS rules must be followed precisely, the LTC policy must meet tax-qualification standards, and you need to make sure the exchange makes sense for your overall financial picture.

A licensed insurance agent can review your existing annuity, help you determine if you qualify for LTC coverage, and walk you through the 1035 exchange process from start to finish. There is no cost for a consultation, and you are under no obligation. If you own an annuity you are not using and you are concerned about long-term care costs, reach out to one of our agents today to explore whether a 1035 exchange could be the right move for you.