Long held annuities can be like a basket full of snakes. A degree of charm is required to avoid unpleasant consequences; in this case, income tax owed on built up gains. While they can provide the advantage of tax deferred growth, annuity withdrawals are generally taxed as ordinary income to the extent that they exceed contributions. This generally requires careful timing of annuity withdrawals to avoid excessive tax liability.
But we now have a new tool in our snake charming kit. If you also own long term care insurance, be aware that IRC Section 1035 tax treatment can now be applied to exchanges from non-qualified annuities to pay long term care premiums. For example, if you owned an annuity worth $50,000, to which you originally contributed $30,000, you will owe income tax on the gain of $20,000. If you qualify for 1035 exchange from the annuity to pay $1,000 in annual long term care insurance premiums, that $1,000 transfer is pro-rated to consist of $600 of your original principal and $400 in gain. If simply withdrawn from the annuity, that $400 in gain would be taxed as ordinary income. But as part of a 1035 exchange to pay long term care premiums, you can avoid tax on that gain.
As with any tax advantage, there are rules that apply. First, the annuity and long term care policy must be of like ownership. Second, the annuity must be non-qualified and the long term care policy must be “tax qualified”. Third, as in the example above, the IRS stipulates that each exchange used to pay long term care insurance premiums consist of a pro-rata share of earnings and principal.
Note that this strategy does not in itself constitute a reason to buy long term care insurance. And if you own an annuity worth less than what you contributed to it, the strategy provides no advantage (i.e. there are no snakes in that basket). For this reason and many others, you should consult a qualified advisor and your accountant to verify how to open the basket without being bitten.
