The Secret to Tax-Free Annuity Distributions

In select cases, annuity owners can take tax-free distributions. Not many people know this, but it can provide a real benefit to people who need long-term care.

Typically when distributions are taken from a deferred annuity, the income and gains are included in gross income and taxed as ordinary income. There’s an exception for distributions that are taken to pay for long-term care. Those distributions are tax free. To qualify, the annuity owner must need assistance with at least two of the activities of daily living (eating, dressing, bathing, walking, etc.), and a medical professional must certify that need.

Not all annuities qualify for this treatment. The annuity must contain language mandated by the 2006 law. So if your annuity predates the law, distributions probably won’t be tax free, and even many annuities issued after then don’t qualify. In fact, only a handful of annuities meet the rigorous LTC qualifications. You need to check with your insurer or insurance agent to determine if an annuity qualifies. When your annuity doesn’t qualify, you can qualify by using a section 1035 tax-free exchange to trade the old annuity for a new one with the right language. There might be surrender penalties for exchanging the old annuity and a commission for purchasing the new annuity. Check all the costs and consequences before deciding if this move is worth while.

Many annuities are used at least partially to pay for long-term care expenses. If you own a deferred annuity or are thinking of buying one, consider the potential for taking a tax-free distribution to help pay long-term care expenses.