Funding long-term care with an irrevocable life insurance trust

How this strategy can help you avoid unnecessary taxation and create generational wealth.

No one wants to assume they’ll need long-term care, but being prepared may give you – and your loved ones – peace of mind. For some, that means finding comfort in purchasing long-term care insurance to help cover medical and non-medical expenses as they age.

Those who have the resources to self-fund long-term care may not consider buying a long-term care policy. However, purchasing one and placing it inside an irrevocable life insurance trust can have benefits beyond the policy itself.

Avoiding unnecessary taxation

Setting aside money for long-term care expenses and using all or most of the funds may serve as proof that self-funding was successful. But, if little or none of the savings set aside was used, the funds earmarked for long-term care could result in a significant estate tax when it comes time to pass assets to the next generation.

To avoid this situation, individuals can purchase a linked-benefit long-term care policy that pays indemnity benefits and place it in an irrevocable life insurance trust. A linked-benefit policy in this case refers to one policy that combines long-term care insurance and life insurance. The death benefit ensures that the premium paid for the policy is protected from loss if the policy is little or never used.

How it works

A carefully designed trust allows the insured to indirectly access funds by borrowing from the trust to pay for long-term care. The trust must be written with provisions for fully collateralized loans. The loan has to be legitimate, secured by property pledged by the insured individual, with interest charged and an agreement to fully pay back the debt.

If the insured needs long-term care, the trustee would file a claim for the long-term care benefit. After it’s approved, monthly benefit payments are sent to the trust. The individual who needs care borrows funds from the trust upon pledging proper collateral and these funds can be used to pay long-term care expenses without any restrictions.

Upon death of the insured, the loan principal and any unpaid interest is repaid to the trust. That amount is deducted from the calculation of assets subject to estate taxes.

The higher the interest rate (within reason), the better this concept works. Interest is allowed to accrue to intentionally increase debt. Interest must be paid back prior to the insured’s death to avoid income taxation to the trust. Upon the death of the insured, the loan principal and unpaid interest would be repaid to the trust. And that same amount would be deducted from estate assets for the purpose of taxation, leaving a smaller estate tax liability.

A case study

Bill uses part of his lifetime exemption to gift $196,032 to an irrevocable life insurance trust. The trust will purchase, own and be the beneficiary of a linked-benefit long-term care policy that pays indemnity benefits and provides a 6-year benefit pool of $1,080,000 in total benefits. The trust will include the loan provisions needed for this concept using an 8% interest rate.

If Bill needs long-term care, he will borrow $1,080,000 from the trust over a 6-year period. If the $308,582 interest accrued is repaid prior to Bill’s death, it will be spared from estate and possibly income tax, saving $123,833. Upon Bill’s death, the guaranteed minimum benefit of $72,000 is paid to the trust. The estate will repay the loan principal, incurring no tax consequences. The net cost of the policy ends up being $199.

If Bill never needs long-term care, the trust receives a tax-free death benefit of $360,000 and he doesn’t subject himself to the unnecessary estate taxation that self-funding could cause, saving up to $400,000 (assuming a 40% tax rate). Even considering the $196,032 he paid for the policy, the additional $563,968 can be left to heirs.

Everyone’s wishes for long-term care and how they plan to fund it will differ, but this strategy may help you avoid unnecessary taxation and result in additional inheritance for your heirs when compared to self-funding.

This hypothetical example is for illustrative purposes only and is not representative of any actual client experience. Individual results will vary.

Guarantees are based on the claims paying ability of the issuing company. Long Term Care Insurance or Asset Based Long Term Care Insurance Products may not be suitable for all investors. Surrender charges may apply for early withdrawals and, if made prior to age 59 ½, may be subject to a 10% federal tax penalty in addition to any gains being taxed as ordinary income. Please consult with a licensed financial professional when considering your insurance options.

Insurance products offered through Raymond James Insurance Group. Raymond James & Associates, Inc. and Raymond James Financial Services, Inc. are affiliated with Raymond James Insurance Group.