Kitces wrote an analysis on the new provisions for a financial book publisher. I invited him to put his findings into lay terms, and this is what he told me:
"As a minor technical statement, you don't take the money out of the annuity; it's deducted directly from the annuity as part of a hybrid annuity-LTC product. If you were to try to withdraw the money from the annuity to pay for long-term care, it would still be fully taxable. So it must be a single hybrid product, where expenses associated with the long-term care premiums are deducted directly from the annuity (or life insurance). This also means that, by definition, you will be required to purchase a new policy in or after 2010 to actually have an appropriate hybrid policy. To my knowledge, none currently exist that actually meet the specifications of the new law.
"Thus, everyone who wants to go down this road in 2010 will have to replace his or her current annuity or life insurance. Fortunately, the Pension Protection Act did provide that an exchange from an old insurance or annuity policy to a new hybrid policy is a nontaxable exchange under IRC Section 1035. But, a new policy will still be required -- which also means forfeiting all the benefits of the old policy, paying any applicable surrender charges, and facing new underwriting requirements for life insurance policies. It remains to be seen whether or how insurance companies will come up with ways to make such a policy replacement easier.
"The primary issue, though, is that you don't get to use the earnings to pay for the long-term care coverage. Technically, you're using your cost basis to cover the premiums, and your gains are still waiting for you -- except in the unusual case where your cost basis has been reduced to zero. Thus, you don't really create any tax savings, because you're never reducing your taxable gain (except in the zero basis case); instead, you're saving money only to the extent that you're able to "harvest" your cost basis for the long-term care premiums while continuing to defer the gain of the earnings. That's still a tax benefit, but a significantly smaller one than actually being able to use the earnings tax-free.
"An example may help. Let's assume that John Smith has a $100,000 annuity with a $75,000 cost basis. Thus, John has a taxable gain of $25,000. If John has $2,000 of long-term care premiums deducted from the annuity as a hybrid product, John's cost basis is reduced by the $2,000 payment. Thus, his annuity value is now $98,000, his cost basis is now $73,000 (the original $75,000 less the $2,000 deduction), and thus his taxable gain is still $25,000 -- which is $98,000 minus $73,000. Thus, John hasn't done anything to reduce the taxes he's eventually going to pay on his $25,000 plus future growth. All he's done is manage to use $2,000 of his $75,000 cost basis without being forced to pay taxes on an annuity withdrawal, but the taxes are still coming in full force at some point down the road. And of course, John Smith would have had to exchange his old annuity for a new hybrid annuity in 2010 just to go down this road."