Individuals can now use proceeds from some annuities tax-free to pay premiums for long-term-care insurance. By Kimberly Lankford, Contributing Editor June 2, 2010 EDITOR'S NOTE: This article was originally published in the April 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.Would you like extra cash to pay for long-term-care insurance premiums? If you own deferred annuities, you may be in luck. Starting this year, individuals can use proceeds from some annuities tax-free to pay premiums for long-term-care insurance. The new tax break was included in the Pension Protection Act of 2006. Besides benefiting current annuity owners, the law is sure to stimulate sales of policies that combine annuities with long-term-care coverage. These hybrid products allow policyholders to use proceeds for long-term-care coverage, for income or for both. Previously, unless the annuity was converted to an income stream, the first withdrawals were considered to come from gains, which were taxed at ordinary-income tax rates. After the gains were withdrawn, the principal could be withdrawn tax-free. Advertisement Now you can transfer money from an annuity to pay long-term-care premiums without owing taxes. If you eventually cash out, you will pay taxes on any remaining gains. Say you have an annuity worth $100,000, which includes $80,000 from your original investment and $20,000 in gains. If you use $2,000 to pay your long-term-care premium, then 80% of that amount ($1,600) will be subtracted from your principal and 20% ($400) will come from the annuity’s taxable gains. As a result, you can use the $2,000 from the annuity without owing taxes now, and the move will reduce your taxable income by $400 when you cash out the annuity. If you transfer enough money from the annuity for long-term-care premiums over time, you could end up erasing the tax bill. This tax break doesn't apply to annuities within IRAs. Terence Holahan, assistant director of long-term-care sales for Northwestern Mutual, is taking advantage of the new tax break himself. Several years ago, he bought a deferred annuity after maxing out his 401(k) and IRA. He recently bought long-term-care insurance and transferred money from the annuity to pay this year’s premium. That freed up cash to save for his children's college costs. Advertisement The new law also lets you transfer money from cash-value life-insurance policies tax-free to pay long-term-care premiums. But this isn't a big deal because with life insurance, your first withdrawals are the tax-free return of principal. The Growth of Combo Policies Insurers already are selling policies that combine annuities or life insurance with long-term-care coverage. With the tax break, owners of hybrid policies will no longer pay taxes on the annuity or insurance proceeds that pay for the policy's long-term-care coverage. Most people will get better coverage if they buy a stand-alone long-term-care policy. But the combination products appeal to people who prefer the flexibility of being able to finance long-term-care coverage if they need it, or to use the policy for other expenses. Advertisement Genworth recently introduced a new version of its long-term-care annuity. You buy an annuity with a lump sum and can use double or triple the premium amount as your long-term-care benefit. A $100,000 investment could provide up to $200,000 or $300,000 in long-term-care benefits. If you choose the $200,000 coverage with a four-year benefit period, the monthly benefit would be $4,200. The premiums within the combo policy are comparable to a stand-alone policy with similar benefits, says Beth Ludden, senior vice-president of long-term-care product development for Genworth. If you need the coverage, the value of the benefit is subtracted from both the annuity's value and the coverage's value. After a person uses $4,200 for a month in a nursing home, there would be $195,800 left in long-term-care benefits and $95,800 left in the annuity. In the past, the policyholder would pay tax on the amount transferred from the annuity to long-term care. If the policyholder uses up the entire annuity, he or she would still have long-term-care benefits left. For more authoritative guidance on retirement investing, slashing taxes and getting the best health care, click here for a FREE sample issue of Kiplinger’s Retirement Report.