New rules governing hybrid long-term-care products go into effect on Jan. 1 and may spawn a new generation of hybrids. Advisors need to think about when and why to consider them for clients.

Sales of long-term-care insurance (LTCI) have struggled, often because clients perceive them as risky. You pay a lot in premiums, which reward you handsomely if you later need extensive care, but which disappear if you die before needing them or never qualify for them.

To address these concerns, product providers developed annuities and life insurance policies with long-term-care riders as less-expensive alternatives. For example, insurers tested the waters with single-premium life policies that had provisions for LTC, usually a multiple of the death benefit paid out over several years. Once the death benefit was exhausted, any remaining claims would be applied against "excess benefits" up to a maximum. If the client didn't have LTC costs, the death benefit would ultimately pay out when the client passed away.

Hybrid LTC products tended to be cheaper because LTC costs came first from the client's original investment-and cost the insurer nothing. If a client bought a life/LTC policy for $100,000 that provided a $150,000 death benefit and ultimately might pay out up to $300,000 for LTC, the client's own $100,000 cash value would typically be tapped first and the insurer would only step in only when those assets were depleted. The insurer assumed less risk than with traditional LTCI, where the insurer would bear the full cost up front.

However hybrid LTC policies turned out to have serious tax problems. With life insurance, while "borrowing" the death benefit prior to one's actual demise to pay for LTC didn't create a taxable event, when the LTC portion of the funds was extracted from the policy it created undesirable taxable "phantom" income for the insured. Hybrid annuity/LTC products also had tax troubles. The Internal Revenue Service viewed LTC costs paid out as taxable withdrawals from the annuity's growth. This and the need to invest a significant lump sum made both products less popular than traditional LTCI.

CHANGING THE RULES

The government addressed the tax issues in the pension protection act of 2006 to encourage the development of more hybrid products. Congress provided that the new rules take effect in January 2010 to allow companies to comply.

The act also clarified that owners of life or annuity policies can make a 1035 exchange into the appropriate hybrid product. Under the new rules, a client can also complete a 1035 exchange for the cash value from any annuity or life insurance policy into a single-premium qualified LTCI policy without realizing any gains.

The new tax treatment is an improvement, but some issues remain. Assume a client buys an annuity/LTC hybrid for $100,000. In the first year, the policy earns 3%, or $3,000, and it pays LTC protection costs of $3,000. The client might assume that the gain will offset the LTC cost with no tax consequences, but that's not what happens. Since the law stipulates that the investment in the policy or annuity has to be reduced, the $3,000 in LTC expenses comes out of the client's $100,000 cost basis and not the $3,000 appreciation, which becomes an embedded ordinary income gain that will someday be recognized when withdrawals are taken or the contract is cancelled. This so-called principal-first treatment has a significant impact on hybrid products' true tax value. Assuming a 30% tax rate, the client's after-tax net worth is now $99,100, or the $100,000 contract minus the $900 in taxes owed on the $3,000 gain.

Ironically, the client would wind up the same-if not better off-if she had bought an annuity for $97,000 and put a separate taxable $3,000 into standalone traditional LTCI. Assuming the same 3% growth, the annuity grows to $99,910 and the taxable account, to $3,090. The client would owe $27 in taxes on the taxable account and $873 in deferred tax liability on the annuity growth. That leaves her with $99,100. But in this scenario, the client, who paid for LTCI with after-tax dollars, may be able to claim some of that expense back as a medical insurance deduction or credit.

If the client received even $1 of a Federal or state long-term-care deduction or credit, the value of the policy would be higher than $99,100. Thus the non-hybrid policy would result in greater wealth because the hybrid policy extracted its LTC coverage costs from the nondeductible cost basis.

However clients who have an interest in hybrids may find that the life insurance option is more advantageous than the annuity product. As long as the policy is held until death, the client can spend down the cost basis and ultimately let the policy expire as a paid death benefit (or LTC claims), never realizing any deferred gains from the policy's growth. With an annuity/LTC policy, the growth will always be realized and taxed, either by the original policyowner or a beneficiary. In the meantime, the client is simply spending her own after-tax cost basis.