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  • Barry Boscoe

Pension Protection Act: A Way to Convert Taxable to Non-Taxable

I was recently asked to speak on a radio show regarding the Pension Protection Act. What follows is the dialogue between the host and myself.

Introduction

The Pension Protection Act also known as the PPA is a wide-ranging piece of legislation enacted in 2006 dealing primarily with changes to pension reform. However, under section 844 of the act it deals exclusively with annuities, long term care and specific tax advantages.


What does the Pension Protection Act (PPA) do for annuities?

Starting in 2010 cash withdrawals from specific LTC annuities used to pay for LTC care expenses or pay for qualifying long-term care insurance premiums were no longer taxable income. In addition, benefits from LTC riders were also tax free.


How are the tax-free benefits possible?

The PPA allows for annuity contracts to include LTC and under the new code section 7702B(e)(1) the coverage is treated as a separate contract for tax purposes. This is due to the separation as set forth under the Health Insurance Portability and Accountability Act or HIPPA the


What is HIPPA?

HIPPA among other things set the standards for LTC to be considered federally qualified and established the benefit payments as not subject to taxation.


What is the difference between qualified and non-qualified LTC?

Qualifing LTC insurance must satisfy several specific benefit and consumer protection requitements.

  1. The individual must be receiving benefits according to a plan of care prescribed by a health practitioner

  2. The individual must be certified as being chronically ill by the inability to perform at least 2 activities of daily living or also known as ADL’s or requiring substantial supervision due to a severe cognitive impairment.

The LTC policy must meet the guidelines of IRC 7702B(b) in order to qualify


However, the rider is not a true Long-Term Care policy under 7702B(b) but instead falls under 101(g). This is known as a Chronic Illness benefit. Payments under this rider are intended for favorable tax treatment under Section 101(g) of the Internal Revenue Code (26 U.S.C. Sec. 101(g)). There may be tax consequences of accepting an amount above the amount that would be tax qualified under the Internal Revenue Code. In addition, you must be permanently disabled in order to collect the benefit and because the benefit cannot be classified as Long-Term Care you may not pay for it as a rider but you will not know what the benefit is until you actually begin to receive the benefits.


How does one know if the annuity is qualified under IRC 7702B(b)?

A qualifying annuity will have language as follows:

“For taxable years beginning on or after January 1, 2010 this contract is intended to be a federally qualifying Long-Term Care insurance contract under Section 7702B(b) of the Internal Revenue Code of 1986 as amended”


Can a regular annuity have tax free withdrawal for LTC or Premiums for LTC?

Every written interpretation indicates an annuity must include the qualifying language under IRC 7702B(b). This will preclude regular annuities.


What can you do with a regular annuity if you wish to use it for LTC tax free

Many annuities are either not performing as desired or were intended to be used for self-insuring Long-term care. If you are in an annuity and would like to convert it to a qualifying annuity without incurring any taxation then a 1035 exchange may be the ticket.

Can you use qualified money to fund under the PPA?

Unfortunately, the act precludes the use of pre-tax sources from the PPA. But there are other opportunities to use pre-tax money to fund a Long-term care plan.


Can you provide us an example of a regular annuity you exchanged for a qualifying LTC Annuity?

I was asked by a law firm to help one of their clients who specifically purchased a regular annuity for $400,000 to help them self-fund a long-term care event. When I met with them they were unaware that the withdrawals they would take to cover their care were going to be taxable on the first moneys coming out. By the time I met them their $400,000 had grown to a little over $1,000,000. What this meant was that the first $600,000 of withdrawals were taxable. In their bracket that meant they would lose about $240,000 to state and federal taxes.


We were able to exchange their regular annuity on a tax free 1035 exchange into a PPA qualifying annuity under IRC 7702B(b). The exchange left them in a similar position as their current non-qualifying annuity with the exception of providing tax-free Long term care withdrawals in the amount of approximately $20,000 each all tax free.


The epilogue to this story is a few years later they did need care and the benefits they received were tax-free. When they died the remaining money in the contract went to their children.


If you think the Pension Protection Act could benefit you or someone you know, please contact me at 818-342-9950 or Barry.bosoce@brightonadvisory.com and we can explore your options.

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