Tax wrinkle is annuity/LTC wild card

Annuities coupled with long-term-care benefits could make a splash next year if the IRS and insurers can hammer out a tax kink that threatens to dull the appeal of the new hybrid.

Insurers have been developing these new products in anticipation of the Jan. 1 effective date of a provision in the Pension Protection Act of 2006 which permits tax-free LTC payouts from an annuity with a tax-qualified long-term-care rider.

Policies written after the start of the year will enjoy the tax-free payouts as will annuities with LTC riders already in force. The rule also allows for Section 1035 tax-free exchanges into these combination products from older annuities.

The tax wrinkle remaining to be worked out involves how the product pays for LTC benefits once the policyholder activates the rider. The American Council of Life Insurers, an industry trade group, and the Internal Revenue Service are discussing the issue.

“Congress blessed these products, and they thought that there would be incentive to buy your own long-term care by allowing the contracts to be paired with annuities,” said Mandana Parsazad, senior counsel for taxes and retirement security at ACLI. “Now we’re under deadline, and the industry and the IRS are getting around to confirming basic rules on the contract.”

In some product designs, a portion of the LTC benefits may be paid out of the cash value of the annuity. This design raises the question of whether the annuity’s basis, as well as the gains in the contract, should be reduced by the benefit payments. The industry believes that benefits paid out of the cash value do not reduce the contract’s basis.

But the IRS disagreed, finding in a private-letter ruling this year that the full amount of LTC benefits paid out of the cash value would indeed reduce the basis in the contract.

In an attempt to resolve the issue before the end of the year, the ACLI last week sent a letter to the IRS and the Treasury requesting confirmation on five tax treatment points: that premiums paid into a combination product be considered basis, that the cost of the LTC rider be reduced from that basis, that qualified LTC benefits be excluded from gross income, that payment of LTC benefits not reduce the investment in the contract and that taxpayers be able to exchange part of an annuity contract for qualified LTC insurance.

“Some issues haven’t been fully addressed,” said Ms. Parsazad. “Products are being designed so they can be rolled out after Jan. 1, and companies want to know as much as they can so they can inform customers of the tax consequences.”

Even if tax issues are not settled wholly in favor of the carriers, hybrids could be attractive, advisers said, because the cost and “use it or lose it” aspects of stand-alone LTC products limit their appeal.

The new hybrid products are typically single-premium deferred annuities, in which the interest earned is greater than the cost of the rider, which is charged against the account value either monthly or annually. Certain features also provide extended benefits, which can pay out two to three times the account value.

A typical hybrid annuity structure pays an accelerated death benefit over two years, plus two years of benefits paid by the insurer. During the first two years of the LTC benefit, however, the money comes from the policyholder’s cash value, thus shifting some risk to the customer. Because of that, the LTC rider may be priced at about a third of the cost of a comparable stand-alone product, according to Carl A. Friedrich, a principal and actuary at the consulting firm Milliman Inc.

“The thrust of the combination product is to try to minimize the pain for the producer and the applicant,” he added. Some combination products already exist, including one from Genworth Financial Inc., and Mr. Friedrich confirmed that his firm is examining products in the pipeline at a few other carriers.

Despite uncertainty over the tax treatment of the LTC riders, carriers are optimistic about the hybrids.

“We still think it’s a compelling proposition, but just a little less compelling, technically, because of the tax potential,” said Beth Ludden, senior vice president of LTC insurance product development at Genworth. Because of the way its company’s products are designed, Genworth isn’t affected by the IRS decision, she said.

Over the past 18 months, Genworth has marketed a pilot hybrid annuity with a 24-month deferral for the use of LTC benefits. It will release a new version in the first quarter which has a 12-month deferral. Like holders of its stand-alone LTC policies, buyers of Genworth’s new hybrid are eligible for immediate coverage of home health care services.

To explain the new coverage, Genworth has developed an educational campaign about the PPA and its provisions for its agents and advisers.

“Agents are waiting until the official Jan. 1 date to go by before they get serious about the product, and I think you’ll see a lot of activity and interest before the first quarter [ends],” Ms. Ludden said.

E-mail Darla Mercado at [email protected].