Bullet: Pension Protection
Act of 2006
Wednesday, February 7, 2007
LTC Comment: PPA
'06 made some big changes in the tax treatment of annuity and LTC
insurance products. What
does it mean? After the
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LTC BULLET: PENSION
PROTECTION ACT OF 2006
LTC Comment: Ever
since I met with then-Treasury official Mark Warshawsky in the Fall of
2005, I've been a believer in the potential to meld annuities and LTC
coverage more effectively. Warshawsky
advocated improving the tax treatment of policies that combine the
benefits of both financial products.
I added that arrow to my quiver of recommendations as I conducted
Hill briefings on how to relieve the fiscal burden on Medicaid by
encouraging private financing alternatives for LTC.
We didn't get the needed changes in the Deficit
Reduction Act. But they
came soon after in the Pension Protection Act of 2006, enacted August
17, 2006. For a copy of PPA
'06 and other information, see http://www.dol.gov/EBSA/pensionreform.html.
Ever since this new law was enacted, I've been
waiting to find some good analysis of its provisions.
For example: what
exactly do they mean? Who's
most likely to be affected? What
effect will the law have on the marketability of long-term care
coverage? Is there hope that it will help to wake people up to the need
to plan for long-term care? Will
it relieve the fiscal burden on Medicaid?
I'm still waiting for this kind of comprehensive
analysis of PPA '06. But in
the meantime, a very interesting analysis of one aspect of the law's
impact was brought to my attention by Center member Sally Leimbach of
Franklin Morris in Baltimore.
The source is Michael E. Kitces, MSFS, MTAX, CFP®,
CLU, ChFC, RHU, REBC, CASL, Director of Financial Planning, Pinnacle
Advisory Group, Columbia, Maryland 410-995-6630, www.pinnacleadvisory.com,
His analysis follows with permission:
how people THINK [the Pension Protection Act of 2006] works. You put
$100,000 into a new 2010 hybrid annuity-LTC product. The annuity earns
$5,000 in growth, raising the cash value to $105,000. The annuity
company subtracts $5,000 of funds from the annuity to cover the cost of
LTC coverage, reducing the cash value back to $100,000 (this cost is
just for illustrative purposes; I realize it's probably high for most
people). Thus, the individual spent $5,000 of growth on LTC coverage and
the contract is still worth $100,000 with a $100,000 cost basis. Thus,
the owner got to use $5,000 of annuity growth tax-free, avoiding all the
taxes that would otherwise have been paid on growth because the contract
now has a value equal to its cost basis. At a 30% marginal tax rate,
that's $1,500 of tax savings. Hooray!
how it ACTUALLY works. You put $100,000 into a new 2010 hybrid annuity-LTC
product. The annuity earns $5,000 in growth, raising the cash value to
$105,000. The annuity company subtracts $5,000 of funds from the annuity
to cover the cost of LTC coverage, reducing the cash value back to
$100,000. HOWEVER, for tax purposes the $5,000 of LTC costs ALSO reduces
the investment in the contract (i.e., cost basis) by $5,000. Thus, the
individual actually finishes with an annuity worth $100,000, and a cost
basis down to $95,000, which means the individual STILL has the full
$5,000 of gains and will still owe every dollar of taxes due on that
growth. All the individual actually did was spend his own after-tax
cost-basis dollars on the LTC coverage.
latter scenario is significantly less favorable than the former. In
fact, the latter scenario, which is how the law REALLY works, is
actually less favorable than NOT using a hybrid policy in many cases. In
the real scenario, the individual is GUARANTEED to spend absolutely ZERO
pre-tax dollars on the LTC coverage, because it must be subtracted from
(i.e., use) after-tax cost basis dollars! In this case, the individual
would have been better off putting only $95,000 into the annuity in the
first place, and writing a check out of pocket for the $5,000 of LTC
coverage; in that case, the individual at least MIGHT have been able to
get a partial tax deduction as a medical expense deduction (to the
extent expenses exceed 7.5% of AGI, and subject to the applicable
age/dollar-limit chart). Even if the individual cannot get any medical
expense deduction, at the extreme that means they're only EVEN with the
real scenario above; the real scenario still never comes out ahead!
(There is a slight exception to this if the cost basis has literally
been reduced to $0, but I would anticipate that will be very rare in
how I replied to Mr. Kitces's message:
So, are you saying there is no benefit to the annuity/LTCi
changes in the Pension Reform Act? Steve
Michael Kitces replied:
might be an overstatement to say there's 'no benefit', but I certainly
see very, very little benefit in almost all situations, at least with
respect to the creation/purchase of hybrid annuity/LTCi and life/LTCi
policies. I DO FIND A LOT OF APPARENT VALUE IN THE NEW PENSION
PROTECTION ACT RULES ALLOWING FOR 1035 EXCHANGES FROM LIFE AND ANNUITY
POLICIES INTO (OSTENSIBLY SINGLE-PREMIUM) LTCI POLICIES.
gut tells me that the way the hybrid policies were drafted wasn't
entirely intentional - I can't believe that Congress would have done it
this way with a full understanding of the practical effect. I suspect
that this was either a pure accident of drafting, or that the cost basis
adjustment was added as a way to control the cost without an
understanding of the associated ramifications on the value of the whole
Comment: We asked Bruce
Moon of OneAmerica, a company that markets annuity/LTC products for his
opinion. He said that
although it's true that taxes will be paid on remaining cash values from
annuity/LTC products, there is still an important advantage, i.e. that
taxes are not owed on qualified LTC expenses.
Any taxes on remaining cash values would be paid by the heirs, if
there is anything remaining after long-term care expenditures are paid.
welcome further comments on the PPA '06 but would particularly like to
receive a thoughtful, comprehensive analysis of less than 1000 words for
publication as an LTC Bullet. Any