Tax Advantages of Hybrid Long-Term Care Insurance

This primer assumes you have a basic understanding of how Hybrid Long-Term Care insurance plans work.  If you’re just starting out and want something more basic, start here.  

If you’re looking to better understand the tax implications of these policies, read on!

Summary:

  • IRS treats Hybrid policies favorably vs. self-funded investments.
  • These policies are MECs, we discuss implications.
  • We give some examples of insuring vs. self-insuring.

Many consumers view insurance through a simplistic lens of “dollars paid in vs. dollars paid out.”  While insurance can definitely provide value, this completely ignores the tax advantages that insurance companies have carved out for themselves and their policyholders in the US tax code.  Many benefits are 100% tax-free, with precedent going back decades and sometimes centuries.  

Comparing your own investment growth rate to that of a life insurance policy completely ignores the fact that Life insurance benefits are tax-free (if done via Hybrid Life insurance plans) whereas the alternative, your own investments, are subject to both state and federal capital gains taxes, inheritance and possibly wealth taxes.

As an example, a single premium $100k hybrid policy may set up a death benefit of $150,000 which sounds like only a 50% increase over your life.  Quite modest.  But consider that to earn $50,000 gain after-tax in your own investments you’d need to earn at least $80,000 under current tax regimes, on average.  

In California, your capital gains tax can be as much as 34% when combined with Federal.  Even in lower-cost states like Florida or Texas, Federal rates alone are as much as 23.8%.  These are all current rates, but let’s think about the future.

Taxes in the future after COVID-19…
With Long-Term Care planning we are not thinking about today, but about the future.  Most analysts expect a post Covid-19 world to come with much higher tax rates.  We borrowed trillions from the future to fund the recovery.  This tilts the balance even more in favor of a tax-sheltered instrument like the Hybrid Life+LTC insurance policy for tax-free benefit growth.

What’s a Modified Endowment Contract?

When you look at your detailed hybrid Long-Term Care illustration, you’ll see mention of how it is a modified endowment contract.  This can raise red flags, understandably so, because taxes are one of the more complicated things any of us deal with.  

A Modified Endowment Contract (MEC) is a policy defined by the IRS where certain uses of the policy are subject to taxes and even a 10% penalty.  Some consider this similar to prematurely pulling funds from an IRA or 401-k, and that analogy is close.  The definition of a policy as a MEC labels it to be used only for specific things tax-free.  

How to pay $0 in taxes

In the case of most all Hybrid LTC policies, you will pay no taxes on Long-Term Care Insurance benefit payments.  You’ll pay no taxes on the Life Insurance benefits.  So if you buy and hold your policy, and use it for its intended purposes, you’ll pay exactly zero dollars in taxes.

The one exception is if you have a Hybrid Long Term Care Insurance plan that pays $370.00 or more per day, then some of the cash benefits may be subject to income tax. To trigger that tax a 60 year old man would have to put in a $300,000+ premium, or about double what the average policy sold.

The details of the tax law are as followed:

“61 Periodic Payments Received Under Qualified Long-Term Care Insurance

Contracts or Under Certain Life Insurance Contracts. For calendar year 2019, the

stated dollar amount of the per diem limitation under § 7702B(d)(4), regarding periodic

payments received under a qualified long-term care insurance contract or periodic

payments received under a life insurance contract that are treated as paid by reason of

the death of a chronically ill individual, is $370.”

So what is taxable?

Among other things, using your hybrid policy for borrowing via policy loans can subject you to taxation.  Additionally, selling or transferring ownership of your policy can incur taxes.  Lastly, doing an early surrender of your policy for its cash value may also result in a tax bill.  The vast majority of consumers are buying these plans with intention of keeping them for their life and using them for LTC coverage only.  If that’s your intention, the fact that these are MEC policies is of no concern.

The taxation of withdrawals under the MEC is similar to that of non-qualified annuity withdrawals. For withdrawals before the age of 59 1/2, a premature withdrawal penalty of 10% may apply. 

Why are these MECs at all?
Because your premium buys so little life insurance and is more focused on long-term care benefits, it fits into the IRS classification of a MEC.  Since your intention is to use the policy as a LTC protection vehicle, and not to take premature withdrawals, the MEC classification is not a problem.

Nationwide CareMatters II

Business owners can deduct approximately 35% of their premiums if they are incorporated as a C-Corp as that is the portion of premiums dedicated to LTC benefits.

An Example: Self Insurance vs Buying Hybrid LTC

One other often overlooked tax savings concept is found by comparing using your Long Term Care Insurance benefits to pay for the care vs. investing your money, growing it and then pulling it out of the investment to pay the LTC bills.  

For example, say you have two neighbors, Bob Adams and Suzy Stone who are both 60 years old.  Bob takes his $100,000 and buys a hybrid long term care insurance plan.  Suzy decides not to buy the insurance, but rather invest the $100,000 herself. 

Suzy earns 7% over the next 20 years on her initial $100,000.  At 7% Suzy’s investment has grown to nearly $400,000 by the time she is 80.  

Bob’s Hybrid Long Term Care plan has grown his benefits to $800,000. 

They both need care in year 21.  Suzy has to sell her stocks and then pay capital gains tax on her $300,000 profit.  Suzy is in a 25% tax bracket so she pays $75,000 in taxes bringing her total amount of money she has to pay her long term care bills down to just $325,000.  Since long term care benefits are not taxed, Bob has the full $800,000 to pay for his care.  

Bottom line, if you think you have a realistic chance of needing care, Hybrid Long Term Care Insurance will provide you more than double the money guaranteed to be there when you need it.

Related Articles

https://www.irs.gov/pub/irs-drop/rp-18-57.pdf  page 29/31 for LTC Tax Law