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When meeting with your high net worth (HNW) clients, you may hear them say that they don’t need long-term care (LTC) coverage because they can afford to “self-insure” those expenses. However, for these clients, a primary goal of estate planning is preserving wealth, and LTC expenses can put a large dent in the estate.

Self-funding LTC coverage carries potential challenges that HNW clients should consider, including:

  • The lost opportunity to potentially earn higher returns on the self-funded assets
  • The unpredictability of the need for long-term care
  • Exposure to avoidable estate taxes that creates a weak link in the estate plan

Lost opportunity, unnecessary estate taxation

Let’s assume your HNW client proposes to set aside $1 million for LTC expenses. If they end up spending most or all of the $1 million, then the self-funding plan worked well enough. However, if little or none of that $1 million gets spent (and we assume the highest 2024 estate tax rate of 40%), estate taxation could result in a bill of up to $400,000.

Furthermore, because self-funding practically demands that your client have liquid assets available inside of their estate in the event they need LTC, they would lose the opportunity to potentially earn higher returns on that $1 million over several — or perhaps many — years.

A potential, cost-effective solution

To avoid this pitfall, your client could purchase a linked-benefit LTC policy that pays indemnity benefits and is owned inside an irrevocable life insurance trust (ILIT).

The primary purpose of a linked-benefit policy is to provide the maximum leverage of LTC coverage with a guaranteed premium. There is a death benefit on the policy, which assures that the premium paid is protected from loss if the policy is used little or never.1 The death benefit is accelerated first to pay LTC benefits, and then a second bucket (extension of benefits) takes over to continue paying benefits until the elected benefits are exhausted. An asset is repositioned, or income is directed on an annual basis to purchase the policy.

Linked-benefit LTC policies can generally be paid for with a single premium or short pay schedules of up to 10 years. Some companies offer the option to pay over 20 years, to age 65 or to age 100. Some companies also allow the policy premiums to be paid monthly, purchasing the same benefit pool as an annual payment mode.

Why an indemnity policy?

An indemnity LTC benefit can work within an ILIT because the benefit would be sent directly to the owner of the policy — in this case, the trust/trustee. The policy would essentially fund the trust with cash via the payment of an acceleration of the death benefit and then from the extension of LTC benefits.

There is no reimbursement of actual LTC expenses on behalf of the insured. The insured individuals should never be given LTC benefits directly, nor can they have claims against the trust for these funds.

Instead, the insured individual, called the “grantor” in trust documents, borrows from the trust to pay for expenses.

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With a carefully designed ILIT using an indemnity linked-benefit LTC policy, the insurance can indirectly access funds by borrowing from the trust to pay for LTC expenses.

How the concept works

The trust needs to be written with provisions that allow for arms-length, fully collateralized loans. The loan must be legitimate and secured by property pledged by the insured individual, with interest charged, and with an agreement to fully pay back debt.

Collateral may be anything that can be appraised or given a fair market value. The insured individual (grantor) can pledge collateral as they borrow as long as the value of the collateral stays current with the total loan balance.

The interest rate charged should be at least equal to the interest that would be charged on a loan from the life insurance component of the policy. The higher the interest rate, the better this concept works, but the rate must remain reasonable because it is a secured loan. Interest is allowed to accrue to intentionally increase debt, which in this case is an advantage.

Ideally, interest would be paid back just prior to death to avoid income taxation to the trust. At the death of the grantor/insured, the loan principal and any unpaid interest would be repaid to the trust. That same amount would then be deducted from the calculation of estate assets subject to estate taxation, leaving a smaller estate tax liability. Principal can be paid back after death with no tax liability.

When the individual incurs LTC expenses: 

  • The trustee will file a claim for the LTC benefit
  • After the claim is approved and the elimination period is met, monthly LTC benefit payments will be sent to the trust
  • The individual borrows funds from the trust upon pledging proper collateral
  • These funds can be used to pay LTC ancillary expenses without any restrictions

A hypothetical case study

An individual sitting on a cushioned window seat, reading in a well-lit room with large windows and neutral decor.

Maria, a 60-year-old female nonsmoker, qualifies for the couple rate. She will use part of her lifetime exemption to gift $196,032 to an ILIT. The trust will purchase, own and be the beneficiary of a linked-benefit LTC 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 the benefits are completely exhausted, her estate will receive a guaranteed minimum death benefit of $72,000. The LTC benefit amount paid to the trust will be $15,000 per month.

Scenario 1: Maria needs LTC

The ILIT trustee will file a claim for the LTC benefit and borrow $1,080,000 from the trust over a 6-year period. It may be wise to borrow amounts that do not align exactly with LTC benefit amounts.2 Interest of $309,582 will accrue, and if repaid prior to Maria’s death, will be spared from estate and possibly income tax, saving $123,833. Upon her death, the guaranteed minimum death benefit of $72,000 is paid to the trust.

After Maria dies, her estate will repay the loan principal, incurring no tax consequences. The policy paid out $1,080,000 in benefits at a net cost of $199, as illustrated below.

IF ALL LTC BENEFITS ARE USED:
Original cost of the linked-benefit LTC policy:
$196,032

Minus the sum of $72,000 in death benefits and $123,833 in estate taxes saved:
$195,833

Net cost of the policy:
$199

Scenario 2: Maria never needs LTC

Upon Maria’s death, the trust would receive a $360,000 tax-free death benefit. More importantly, she would not have subjected herself to the unnecessary estate taxation that self-funding could cause. In this example, as much as $400,000 in estate taxes (40% tax rate) could be avoided.

The net outcome of not needing LTC would be the $360,000 death benefit plus up to $400,000 in tax savings. After subtracting the cost of the policy of $196,032, an additional $563,968 could be left to heirs.

IF NO LTC BENEFITS ARE USED:
$360,000 in death benefits and $400,000 in tax savings equals:
$760,000

Minus the cost of the policy:
$196,032

Equals the additional net amount going to heirs:
$563,968

 

Summary

Regardless of whether your high net worth client ever needs long-term care, purchasing and making an ILIT the owner of a linked-benefit LTC policy can result in additional funds being transferred to heirs and avoiding the unnecessary taxation that self-funding LTC expenses could create.

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[1] This assumes there are no withdrawals or loans taken from the policy that would result in an adjustment of the LTC benefits and death benefit. Some policies may not pay a death benefit that is fully equal to premiums paid, depending on the carrier and product. Please refer to the policy illustration and contract.

[2] Some of the plans of this type will set up the interest to be repaid on a periodic basis to hedge against the risk that all interest could be taxable at death, though this will impact the advantage of compounding of the debt. Please consult an attorney for guidance on a lending process within the ILIT.