Millions of Americans hold life insurance contracts purchased decades ago, when their circumstances looked very different from where they stand today.
The children have grown up, the mortgage is paid off, and the original reason for that death benefit has faded considerably over the years.
Fidelity is drawing attention to a tax code provision that allows policyholders to convert those aging contracts into long-term care coverage without triggering a single dollar in taxes.
The strategy involves a mechanism called a 1035 exchange, and it could address one of the largest uninsured risks facing retirees across the country.
Roughly 80% of Americans turning 65 today will need some form of long-term care during their lifetime, according to the Center for Retirement Research at Boston College.
How the 1035 exchange converts old policies into long-term care coverage
A 1035 exchange is a provision under Section 1035 of the Internal Revenue Code that permits a tax-free transfer from one insurance contract to another qualifying policy of similar kind.
The Pension Protection Act of 2006 expanded this rule to include qualified long-term care insurance as an eligible destination, with the change taking effect in 2010.
David Peterson, head of advanced wealth solutions at Fidelity, outlined scenarios in which policyholders may benefit from exploring a 1035 exchange.
Those include situations where the death benefit is no longer needed, where the existing policy is underperforming, or where the policyholder still qualifies for long-term care coverage.
David Blount, insurance planning specialist at Investment & Insurance Planning Services, says policyholders should review modification options before committing to a 1035 exchange.
Sometimes the policy they already own can be modified, and they don’t need to do a 1035 exchange…It’s important to explore all your options when considering whether to keep life insurance, and that includes 1035 exchanges
The transfer must move directly from the original insurer to the new insurance company to preserve its tax-free status, Fidelity’s Wealth Management Insights team noted.
If the policyholder withdraws the funds first and then purchases a new policy separately, the transaction becomes taxable as ordinary income.
Long-term care costs exceed $122,000 a year for nursing home residents
Americans collectively spend more than $400 billion annually on long-term care services, and those costs continue to climb faster than most households can save, JRC Insurance Group reported.
The national median cost of nursing home services runs $122,275 per year overall, with private rooms averaging $129,575 and semiprivate rooms $118,500. Assisted living runs approximately $74,400 and home health services about $80,080 annually, the firm noted.
Women need an average of 3.7 years of care over their lifetimes while men average 2.2 years, and roughly 20% of those over 65 will require care lasting more than five years, according to the Administration for Community Living.
Medicare does not cover most long-term care expenses for retirees
Medicare pays for up to 100 days of skilled nursing care following a qualifying hospital stay, but it does not cover custodial or personal care, which represents the vast majority of long-term care spending.
Only about 2% to 3% of Americans, roughly 7 to 8 million people, have long-term care insurance, and three-quarters of people aged 45 and older lack adequate financial preparation for those expenses, JRC Insurance Group reported.
Families absorb roughly 70% of total long-term care costs on their own, and the average lifetime expense exceeds $150,000.
“It’s not always about tax avoidance,” David Blount said in an interview with MassMutual’s blog. “It’s about transferring risk and getting the most benefit you can from your dollars.”
Health and timing can disqualify policyholders or shrink the benefit of a 1035 exchange
The 1035 exchange offers clear tax advantages, but several conditions can disqualify a policyholder or reduce the financial benefit of the transfer, and timing plays a significant role in the outcome.
Applicants aged 60 to 64 face denial rates of approximately 30% when applying for long-term care coverage, while that figure rises to 38% for those aged 65 to 69 and reaches 47% for applicants between 70 and 74, according to the American Association for Long-Term Care Insurance.
More Fidelity:
- Fidelity breaks down IRA rules that catch heirs off guard
- Fidelity warns Roth IRA conversions can backfire
- Fidelity, Vanguard have a warning for anyone taking RMDs
“In essence, you are able to pull out the accumulated interest that would have otherwise been taxed, and because you are using it to fund a long-term care policy, it is a tax-free transaction,” Aaron Skloff, chief executive officer of Skloff Financial Group in Naples, Florida, told MassMutual in an interview.
He cautioned that the exchange may not be appropriate for policyholders whose health has declined since they originally purchased their existing coverage.
Surrender charges on the original policy can also reduce the amount of money available for the new contract, and any outstanding policy loans at the time of exchange can trigger unexpected tax consequences on the unpaid balance.
What policyholders should consider before initiating a 1035 exchange
The tax savings are significant, but denial rates climb steeply after age 65, and surrender charges or outstanding policy loans can erode the transfer’s value before a new contract is even issued.
Fidelity recommends that policyholders considering a 1035 exchange consult both a financial professional and a tax professional to review current and future insurance needs and understand any tax consequences before initiating the transfer.
The 1035 exchange remains a rarely used but legal planning route, and as Fidelity and MassMutual both note, the benefit narrows as underwriting eligibility declines with age.
