Why You Should Avoid Tax Favored Long Term Care Insurance Policies

Sometimes a tax break costs more than it is worth. That just might be the case with the breaks for long-term care insurance that were enacted in 1996. All the questions still aren’t answered, but so far it looks like you might be better off taking a pass on these tax benefits.

Congress meant well in the 1996 law. Many older Americans don’t want to saddle their spouses and children with big nursing home bills, and even many baby boomers are starting to consider seriously long-term care policies for themselves. So Congress decided to help out by creating two tax breaks for these policies.

Under one provision, benefits received from a long-term care policy would be tax free, just as benefits paid under an accident or health policy have been tax free for decades. That law also said that benefits paid under policies that were purchased before 1997 and that met state law requirements would be tax free.

The other benefit is to allow medical expense deductions for premiums paid on long-term care policies. The maximum deduction depends on your age. Those under age 40 can deduct a maximum of $200 annually; up to age 50 can deduct $375, up to age 60 can deduct $750, age 60 to 70 can deduct $2,000, and older than 70 can deduct $2,500 annually.

Now here’s the big problem. To get these benefits, your long-term care policy has to be “tax qualified”. That means it has to meet certain requirements set out in the tax code. That sounds like a good deal; the government won’t give tax breaks for policies unless they provide a minimum level of benefits.

But the unfortunate fact is that non-tax qualified policies pay better benefits than tax qualified policies. Some in the insurance industry will state flat out that the qualified policies are inferior. Most insurance companies appear to be pushing the qualified policies because they are more profitable. Insurers expect 20% to 40% lower claims under the qualified polices than under nonqualified policies.

For example, to get benefits under a qualified policy the individual must be unable to perform at least two of the activities of daily living (dressing, bathing, eating, etc.) and a doctor must certify that the condition will continue for at least 90 days. That leaves out a bunch of people who enter nursing homes for short-term rehabilitation. It also excludes people who enter a nursing home because the doctor says it is a medical necessity. Moreover, tax qualified policies don’t include walking as an activity of daily living. People who enter nursing homes because they are frail or need help getting around might not get benefits under a tax qualified policy.

You also shouldn’t get too excited about the tax deductions for long-term care policies. The deductions are available as medical expenses only if you itemize deductions. In addition, you get a benefit only to the extent that these premiums and your other unreimbursed medical expenses exceed 7.5% of your adjusted gross income. Most of you won’t get any additional deductions from these policies.

The alternative, if you want a long-term care policy, is to buy a nonqualified policy. Under these policies you pay for the benefits you want, rather than the benefits required by the tax code. The catch at this point is that you don’t know if benefits received under a nonqualified policy in the future will be tax free. There is a possibility that the IRS will rule that nonqualified long-term care policies are not health insurance, so the benefits are taxable. (Insurers have to begin issuing Form 1099s for payments made under long-term care policies.)

One option is to count on having savings to pay the taxes. Your spouse and heirs will be better off helping to pay your income taxes than paying the nursing home expenses. Or you can buy a nonqualified policy that lets you convert it into a qualified policy if the IRS rules unfavorably on nonqualified policies.

The new tax benefits for long-term care don’t amount to much. You probably are better off deciding if you want a long-term care policy and which policy terms are best for you (see my _____ issue for details). Then buy that policy, whether it is tax-qualified or not. If the policy is not tax qualified, incorporate in your planning the possibility that the benefits might be taxed when you receive them. The tax breaks in the law aren’t worth compromising your needs to get the tax breaks.