Long Term Care Insurance: Don’t Be Surprised By Taxes!

By Tabitha Lamontagne February 6, 2012

February 2012

As life expectancy increases, so does the need for long-term care.  The cost of long-term care can be significant and can quickly deplete personal assets.  As you consider the purchase of a long-term care insurance policy it is important to confirm that it meets the definition of a qualified long-term care contract (QLTC) as defined by the Internal Revenue Code.

Note that long-term care insurance should not be confused with disability insurance.  Long-term care insurance covers health care services provided in a nursing home, assisted living facility or policy holder’s home.  It provides benefits based on the beneficiary’s inability to perform specified daily functions.  By contrast, disability insurance replaces a portion of lost wages resulting from injury or sickness.

Why does it matter?

Qualified and non-qualified contracts are treated very differently for tax purposes.  Generally a QLTC is treated for tax purposes as an accident and health insurance contract, which holds a favorable tax status both in terms of the premiums paid on the policy and the benefits received under it.  Benefits received from qualified contracts are tax-free, while benefits received from non-qualified contracts are fully taxable as ordinary income.  Premiums paid for a QLTC are deductible medical expenses, while premiums paid for non-qualified contracts are not deductible expenses. (Note that medical expenses often are subject to additional limitations.  For the self-employed, qualified medical insurance premiums may be fully deductible.  For all other individuals, qualified costs generally are deductible only to the extent that total medical costs exceed 7.5% of Adjusted Gross Income).

How to tell if a policy is qualified

In general, to qualify the insurance must cover only qualified long-term care services, which include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitative services; and maintenance or personal care services which are required by a chronically ill individual, and are provided pursuant to a plan of care prescribed by a licensed health care provider.  Additionally, the policy must not pay or reimburse expenses generally covered by Medicare; must be guaranteed renewable; cannot have a cash surrender value; and all refunds of premiums, policyholder dividends or similar amounts under the contract are to be applied as a reduction in future premiums or as an increase in future benefits.  Policies that pay benefits on a per diem or other periodic basis without regard to expenses incurred can still meet the qualified contract requirements, but the non-taxable benefits received may be limited.

This is merely a partial summary of the rules, which are found in Internal Revenue Code Section 7702B.  From a practical perspective, though, reputable insurance companies and their agents will have accurately made the determination for you, and often may provide assurance in writing.  CPAs or attorneys who are proficient with these rules can help, too.

Other

This article primarily addresses the tax impact of qualified vs. non-qualified long-term care insurance contracts on individuals.  This article does not attempt to explain the taxability, deductibility and reporting of long-term care insurance costs for business entities and their employees and members.  Also, note that states may have unique rules regarding tax treatment of long term care premiums and policies.

Conclusion

Expenses for long-term care can be significant.  It is important that long term care insurance policyholders know whether their contracts are tax-qualified.  Without that verification, taxpayers may miss out on beneficial deductions related to premiums or incur unexpected tax liabilities when the policy pays benefits.