Or Why 7702(b) Matters for Long Term Care Planning

No, this is not a dissertation on Hamlet Act 3 Scene 1, although considering whether a product meets the IRC section 7702(b) guidelines can seem like it.

Let’s set the scene and provide the backstory. Some states, like Washington, are considering offering a minimal long term care benefit funded by a payroll tax. California, with its 16 million strong workforce, is also considering this publicly funded benefit. Rumor has it (via the feasibility study) that the legislation may allow an exemption from the payroll tax if the employee already owns private long term care insurance. Like Hamlet, it’s important to understand what is “to be or not to be” by looking at the product types that may qualify for an exemption. In this article we explain what section 7702(b) is, how it works, how it differs from chronic illness riders (IRC 101(g)), and the advantages and disadvantages of each.

What is Section 7702(b)?
Not all long term care insurance policies and riders are created equal. Some may offer more benefits, more flexibility, and more tax advantages than others.

Section 7702(b) is a part of the Internal Revenue Code (IRC) that defines what constitutes a qualified long term care insurance contract and how it is treated for tax purposes. According to Section 7702(b), a qualified long term care insurance contract must meet certain requirements, such as:

• It must provide only coverage of qualified long term care services.
• It must be guaranteed renewable.
• It must not provide for a cash surrender value or other money that can be paid, assigned, pledged, or borrowed.
• It must provide that refunds (other than refunds on the death of the insured or complete surrender or cancellation of the contract) and dividends under the contract be used only to reduce future premiums or increase future benefits.
• It must meet certain consumer protection standards set by the National Association of Insurance Commissioners (NAIC)

Qualified long term care services are defined as necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, rehabilitative services, and maintenance and personal care services that are:

• Required by a chronically ill individual; and,
• Provided pursuant to a plan of care prescribed by a licensed healthcare practitioner.

A chronically ill individual is someone who has been certified by a licensed health care practitioner as:

• Being unable to perform at least two activities of daily living (such as eating, bathing, dressing, toileting, transferring, and continence) without substantial assistance from another individual for at least 90 days due to a loss of functional capacity; or,
• Having a severe cognitive impairment (such as Alzheimer’s disease or dementia) that requires substantial supervision to protect his or her health and safety.

Why is Section 7702(b) Important?
Section 7702(b) is important because it provides certain tax benefits for qualified long term care insurance contracts. Specifically:

• The premiums paid for qualified long term care insurance contracts are treated as medical expenses and may be deductible (subject to certain limits) if the taxpayer itemizes deductions on Schedule A.
• The benefits received from qualified long term care insurance contracts are generally excluded from gross income as amounts received for personal injuries or sickness.
• The distributions from life insurance policies or annuities that have qualified long term care insurance riders are also excluded from gross income (up to certain limits) if they are used to pay for qualified long term care services.
• Business owners may be able to take a first-dollar tax deduction as a business expense on some or all of the qualified long term care insurance premiums for themselves or employees.
• Individuals may be able to withdraw premiums as a qualified medical expense pre-tax from a health savings account (HSA), health reimbursement arrangement (HRA), or medical savings account (MSA) annually up to an age-based limit.
• States considering a payroll tax to fund a minimum long term care benefit may exempt individuals from the tax if they own a long term care policy that meets the 7702(b) requirements.

These tax benefits can make qualified long term care insurance contracts more affordable and attractive for consumers who want to protect themselves from the high costs of long term care.

What are 7702(b) Qualified Riders?
Besides a 7702(b) traditional LTCI policy, a 7702(b) rider is an add-on or feature to a life insurance policy or an annuity contract that provides long term care benefits in accordance with Section 7702(b). It allows the policyholder to access some or all the death benefit or cash value of the policy or annuity while he or she is alive if he or she becomes chronically ill and needs long term care services.

A 7702(b) rider can offer several advantages over a stand-alone long term care policy, such as:

• Providing multiple benefits in one product: Life insurance/annuity plus long term care coverage.
• Avoiding premium increases: Once the rider is purchased, the premium is often fixed and guaranteed not to increase unless the base policy premium increases.
• Preserving some value for heirs: If the rider benefits are not exhausted by a long term care event.

How do 7702(b) riders work?
A 7702(b) rider allows you to access some or all your life insurance death benefit or annuity value while you are still alive if you meet certain conditions. Typically, these conditions include:

• Being certified by a licensed health care practitioner as a chronically ill individual. This means that you are unable to perform at least two activities of daily living (such as bathing, dressing, eating, toileting, transferring, and continence) without substantial assistance for at least 90 days; or you have a severe cognitive impairment that requires substantial supervision for your health and safety.
• Satisfying an elimination period. This is a waiting period (usually between 0 and 180 days) before you can start receiving benefits from your rider.
• Submitting proof of claim and receipts for eligible expenses. You need to provide evidence that you have incurred qualified long term care expenses that are covered by your rider.

• Depending on the type and design of your rider, you may receive benefits in one of the following ways:
• Reimbursement: You receive a monthly benefit equal to the actual amount of qualified long term care expenses that you incur up to a maximum limit.
• Indemnity: You receive a fixed monthly benefit regardless of the actual amount of qualified long term care expenses that you incur if you meet the eligibility criteria.
• Cash Indemnity: You receive a monthly cash payment if you meet the eligibility criteria.

The benefits from your rider will reduce your life insurance death benefit or annuity value by the same amount. If you exhaust your entire death benefit or annuity value through your rider benefits, your policy or contract will terminate, and no further benefits will be payable.

Advantages and Disadvantages of 7702(b) Riders

Advantages of 7702(b) Riders:

• Tax advantages: The benefits from your rider are generally income tax-free if they do not exceed certain limits set by the IRS.
• Your premiums for your rider may be deductible for income tax purposes if they meet certain requirements.
• Certain products offer riders with an extension of long term care benefits that significantly exceed the original death benefit.
• Certain products offer features that significantly enhance the long term care coverage like guaranteed compound inflation protection to grow the long term care benefits annually on either the base coverage, the rider, or both.
• Flexibility: You can use your rider benefits for any qualified long term care expenses regardless of where they occur (at home, in a facility, etc.). You can also choose among different types of riders depending on your needs and preferences.
• Protection: You can protect yourself from the rising costs of long term care services without having to buy a separate stand-alone policy. You can also preserve some assets for your beneficiaries if you do not use up all your death benefit or annuity value through your rider benefits.
• No use-it-or-lose-it risk: Products allow the unused portion of the death benefit to remain intact and paid to the beneficiaries or will even pay a residual death benefit in addition to long term care benefits being used in full.

Disadvantages of 7702(b) Riders:

• Cost: Adding a rider to your life insurance policy or annuity may increase your premiums or fees significantly depending on factors such as age, health status, type, and amount of coverage.
• Qualification: Not every life insurance or annuity policy offers a long term care rider and some riders have limited health underwriting.
• Premium payment flexibility: Several products require premiums to be paid over a shorter period of time such as a lump sum or over 10 years to get the best value for the long term care benefits.

Chronic Illness Riders: How 101(g) Riders Differ from LTC Riders
There is confusion regarding how a long term care rider differs from a chronic illness rider, a rider that does not qualify as a long term care rider under section 7702(b). A chronic illness rider is a type of rider that complies with IRC section 101(g). They can be added to a life insurance policy to help pay for permanent qualifying events. More recently, some 101(g) products allow for payments even if the chronic illness is not expected to be permanent. A chronic illness rider is like a long term care rider, where two out of six Activities of Daily Living (ADLs) or severe cognitive impairment can trigger benefits, and a licensed health care provider—such as your doctor—will have to certify this.

• A chronic illness rider may provide some flexibility over a long term care rider, such as:
• Less extra rider premium: The extra premium for the chronic illness rider may be minimal or already included in the base life insurance policy. However, often the result of the no extra rider premium products is a reduced death benefit.
• Better life insurance features: Often 101(g) products offer greater death benefits, better cash value accumulation, and other features desirable for life insurance protection.
• Speed-to-market: For carriers, the 101(g) filing process may be quicker, and agents may not have to take additional long term care continuing education to offer these products.

A chronic illness rider may have drawbacks, such as:

• No standard benefit language: Chronic illness riders vary widely in their contractual definitions and special care must be paid to whether permanency of disability is required, the definition of chronic illness that results in claim eligibility, whether the death benefit is discounted, and many other contractual details.
• Limited benefit amount: The 101(g) benefit amount may be capped at a percentage of the death benefit. For instance, an acceleration of two percent to five percent per month up to a total of 50 to 90 percent of the death benefit.
• No inflation protection: The benefit amount usually does not increase with inflation and may lose purchasing power over time.
• Not marketable as long term care insurance: Chronic illness riders are not allowed to be called long term care insurance and may be excluded for the purposes of the exemption from a potential payroll tax depending on a state definition.

Wait, what?

This is where the confusion happens. States allowing for an exemption from a payroll tax, like Washington and possibly California, may require that a product meet the 7702(b) requirements. One of the reasons for requiring a policy to comply with the 7702(b) guidelines is to make sure that it offers sufficient and suitable coverage for long term care needs, and that it matches the state’s goals for its own program. The goal being to reconcile the exemption criteria with the federal standards, and to prevent possible conflicts or confusion between state and federal tax rules.

“To Be or Not to Be…?”
Choosing between a long term care rider and a chronic illness rider depends on several factors, such as health status, financial situation, tax bracket, and personal preferences. But when considering a product that will qualify as long term care insurance, particularly for tax purposes, make sure that it is compliant with IRC section 7702(b). For that is, indeed, the relevant question.