Private Annuities as an Aid
to Medicaid Eligibility

Author:
Michael David Schulman, CPA/PFS
Schulman & Co., CPA, P.C.
New York, NY

Editors note: For further information, contact Mr. Schulman at
(845) 928-7336 or michael@schulmancpa.com.

Clients often ask CPA PrimePlus practitioners, How can I qualify for Medicaid? For too many older adults, Medicaid is the only way to pay for long-term care. As the population ages, more and more older adults face the need to enter a nursing home or other long-term care facility. The costs associated with this can be crippling. With monthly nursing home costs between $5,000 and $7,500, many families find themselves unable to provide this critical care.

Most adults understand the basics of Medicaid eligibility in terms of income and asset limits. In New York, effective Jan. 1, 2004, an individual with annual income in excess of $7,900 and assets in excess of $3,950 cannot qualify for Medicaid. For a couple, the income and asset limits are $11,400 and $5,700, respectively. Each state sets its own limits.

Medicaid eligibility requires many to self-impoverishdispose of sufficient assets to reduce their asset and income levels to qualify for Medicare under their states limits. Quite often, this entails giving assets away to children, grandchildren or others.

Medicaid requires full disclosure of any gifts in the preceding 36 months, or any gifts to a trust in the past 60 months (look-back periods). The gift is divided by the average monthly nursing home cost to determine the length of time the applicant has to wait until he or she becomes eligible for Medicaid.

Example 1: On June 1, 2004, E applies for Medicaid. An analysis of her finances discloses a $150,000 gift to her niece in December 2003. E lives in San Francisco, where the monthly cost of a nursing home is $7,500. Dividing $150,000 by $7,500 gives a 20-month period of ineligibility from December 2003. (Note: the period of ineligibility begins at the gift date, not the date of the Medicaid application.)

Although gifting assets might be an effective way to impoverish oneself for Medicaid eligibility purposes, certain non-Medicaid problems can occur:

• There might be a gift tax.

• Not only are the assets lost, so is the income that they produced.

• The recipient receives the property with a carryover basis. If the assets have appreciated, the gains will be taxed when the recipient ultimately disposes of the property.

Example 2: In anticipation of a Medicaid application, J gifts his marketable securities portfolio to his only child, S. Js cost basis was $150,000 and the fair market value was $500,000. If S sells the entire portfolio for $550,000, he will pay a tax on the $400,000 gain. Further, J no longer has the dividend stream as income to pay for medical expenses.

  

Types of Annuities

For many individuals, their largest asset (other than a residence) is their retirement account. If gifted property comprises qualified assets (e.g., IRAs and tax-deferred variable annuities), an account owner would have to pay income tax on the transfer. If under age 59¹/2, he or she will have to pay withdrawal penalties, as well.

Because asset divestiture is an important Medicaid strategy, exactly how to divest is extremely important. Medicaid takes a rather broad view of the notion of available assets, so any transfer has to be structured properly (i.e., within Medicaid guidelines), depending on the particular asset. In this light, annuities (especially private annuities) are often an excellent way to transfer funds.

An annuity is a contractual arrangement in which a taxpayer gives money to a third party (usually, but not necessarily, an insurance company), and that party agrees to a schedule to pay back the money to the purchaser. Annuities can be classified in two general ways:

• Fixed versus variable: This refers to the way the funds inside the annuity contract are invested. In a fixed annuity, the money is invested at a stated rate of return, which may occasionally vary. Insurance companies guarantee the return and assume the risk of investment performance. In a variable annuity, the contract owner determines how the balance is invested, by selecting from a group of available sub-accounts (similar to mutual funds). A fixed- income option may also be available. With a variable annuity, the owner assumes the investment risk.

• Immediate versus deferred: In an immediate annuity, payments to the contract owner begin once the annuity is established, or shortly thereafter. In a deferred annuity, the contract goes through an accumulation phase and begins to pay once the owner requests it. These deferred annuities are used for retirement savingsmoney is invested during the owners earning years; payouts begin after retirement.

Advantages and disadvantages: The main problem with deferred annuities for Medicaid applicants is that the money in the contract can be withdrawn by the contract holder, making the annuity a countable resource, which defeats the purpose. In truth, annuity contract withdrawals are subject to surrender charges; nevertheless, such contracts are still considered Medicaid available assets.

Another disadvantage in using commercial immediate annuities for Medicaid eligibility relates to death benefits. When the owner/annuitant dies, the payments cease, usually with no residual benefit. For a person dying soon after purchasing a contract, this can be a substantial loss of family assets.

Structuring Private Annuities

As mentioned above, insurance companies do not have to issue annuity contracts; an individual can issue one. For example, a parent can purchase an annuity contract from his or her children. The child receives the parents money in exchange for a written, contractual promise to pay the stated monthly benefit. These so-called private annuities become a powerful tool in Medicaid planning. When the owner/annuitant dies, the remaining money rests with the contract issuer, usually the child, which is exactly what the taxpayer wanted.

State Requirements

Tax advisers need to exercise care when structuring private annuities for this purpose; however, to avoid having the annuity balance count as an available asset, they have to meet state requirements, such as:

• The annuity must be actuarially sound. It cannot guarantee payments for more than the expected life of the annuitant. Often, expected life means the lesser of the annuitants actuarial life or expected life given his or her physical condition.

• The annuity must be in force before the Medicaid application is made.

• The annuity must be irrevocable; once the contract is purchased, the owner cannot get his or her money back. An annuity that permits the contract to be cashed out with a large surrender penalty is not irrevocable.

• The annuity must be nonassignable, to ensure that the contract has no residual cash value.

Here are some examples of immediate annuities used as private annuities in Medicaid planning:

• Life Only: This annuity covers one life (the annuitants life) and all annuity payments cease completely at death. No provision is made for heirs. As discussed above, a substantial loss may incur if the annuitant dies early. This type of annuity is recommended only when a client has no heirs or if the heirs have their own assets.

• Single Life with Refund: Like the Life Only annuity, this option covers the Medicaid applicants life and also provides for beneficiaries/heirs if the annuitant dies within a pre-set number of years. To qualify under the Medicaid guidelines, the number of years guaranteed (period certain) cannot be longer than the annuitants actuarial life expectancy (see Exhibit 1 below). According to estate recovery rules established by the Omnibus Reconciliation Act of 1993 (OBRA 93), any income that passes to heirs after the Medicaid recipients death may be subject to recovery by the state.

• Term Certain: These annuities have no life contingency component. The number and amount of the payments are guaranteed, whether to the owner/annuitant or to his or her beneficiaries. This type of annuity will assure the owner of no loss in the value of his or her estate due solely to an early death. Under the OBRA 93, the guarantee period must be no greater than the stated actuarial life expectancy.

• Balloon (staged) Contracts: Payments under this kind of annuity are structured to pay out a nominal or increasing return during the coverage period; at the end of the period, they pay out a lump sum.

Other aspects of private annuities:

• The client pays no gift tax on the transfer of funds to the annuity, if the annuity is actuarially sound.

• If the annuity payments terminate at death with no residual value, nothing will be included in the annuitants estate. Any appreciation in the transferred assets is removed from the annuitants estate.

• Payments to the annuitant are part income and part capital return. Once the annuitys purchase price has been recoveredusually at the expected lifeall payments are taxable in full.

• Payments to the owner/annuitant are income and count toward Medicaid eligibility to the extent not used to pay medical expenses.

• If the annuitant outlives his or her life expectancy, the annuity becomes more and more costly to the family member issuer.

• If it is determined that the annuity owner does not need to enter a nursing home, the private annuity can hinder the ability to enter and pay for a non-nursing-home long-term facility. (Caution: If a child, in an attempt to help his or her parent afford housing, gifts back some money to the parent, this increases the risk that the entire annuity contract can be deemed available to the parent at a subsequent Medicaid application.)

Conclusion

Medicaid is a complex government program. What is good for one family will not necessarily work for others. In many cases, private family annuities are an excellent vehicle to transfer assets to a related party and not run afoul of the Medicaid eligibility rules. Because Medicaid is state administered, familiarity with the laws of the specific states in which clients reside is essential.

Caution: Before adopting the concepts set forth in this column, tax advisers should carefully discuss with a client the ramifications of becoming a Medicaid recipient. Medicaid was designed as a safety net for individuals with limited income and assets who are unable to pay for medical care, including long-term care. Further, although Federal regulations require that Medicaid and private-pay residents in nursing homes receive the same level of care, differences exist: a private room versus a semi-private room; a small monthly spending allowance for personal needs, etc. In addition, any income the Medicaid recipient might receive from Social Security, pensions, etc., will be used to defray the cost of care.

The average stay of a person in a nursing home is 2¹/2 years. A clients family history might indicate whether the client could be expected to remain longer: If the clients parents lived to an extremely old age, the client might be expected to have a longer nursing home stay. On the other hand, poor and deteriorating health might indicate a shorter stay. If a client has substantial monthly income sufficient to cover most, if not all, nursing home care costs, qualification for Medicaid benefits might not be a logical choice. Although paying for such costs outright might put a slight dent in the estate ultimately transferred to heirs or beneficiaries, it might be offset by increases in the value of property or investments.