By Marc Gilman
(800) 927-9326 |
Two annuity illustrations can both mention an “ADL benefit,” use the same 2-of-6 activities of daily living language, and still be taxed in completely different ways. The difference isn’t marketing — it’s whether the benefit is actually structured as a 7702B-qualified long-term care rider, or whether it’s an enhanced withdrawal feature on an income rider that just happens to be triggered by an ADL determination. Those are not the same thing, and mixing them up is an easy, costly mistake.
Key Takeaways:
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A genuine 7702B-qualified LTC rider pays benefits that are excluded from income up to the applicable per diem limit — that’s the specific tax treatment covered under IRC Section 7702B, and it requires the product to be actually structured and filed as a qualified long-term care insurance contract.
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An income rider with an “ADL benefit” enhancement is often something different — a feature that increases your withdrawal percentage or payout if you can’t perform certain activities of daily living, but the money itself is still an ordinary annuity distribution, not a distinct LTC benefit.
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The tax treatment for that second category follows standard annuity distribution rules, not 7702B: LIFO for non-qualified funds, meaning earnings come out and are taxed first, and full ordinary income tax for qualified funds. Even among income riders, it depends on the mechanics — a GLWB pays via withdrawal (LIFO), while a GMIB requires annuitizing to use, which switches to exclusion ratio treatment instead.
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Nationwide CareMatters Annuity is a real example of the first category — a cash indemnity product structured specifically as 7702B-qualified LTC coverage linked to a deferred annuity, with benefits generally tax-free up to the HIPAA per diem limit.
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The only way to know which category a specific product falls into is to check how it’s actually structured and filed, not by whether the marketing materials mention “ADL” or “long-term care” language.
Why Do Two Products That Sound the Same Get Taxed Differently?
The confusion almost always comes down to structure versus language. Insurance companies build income riders — commonly GLWB-style riders — that guarantee a lifetime withdrawal percentage from an annuity. Some of these riders include an enhancement: if you’re certified as unable to perform a certain number of activities of daily living, your withdrawal percentage increases, sometimes doubling, for a period of time. That enhancement is a real, valuable feature. But unless the rider itself is specifically built, filed, and administered as a qualified long-term care insurance contract under 7702B, the money you receive is still just an annuity withdrawal — a bigger one, but not a different tax category.
A true 7702B-qualified LTC rider works differently from the ground up. It has its own defined benefit pool, its own certification and claims process tied to the statute’s specific “chronically ill” definition, and its payments are treated under the tax code as long-term care insurance benefits, not as withdrawals from your annuity’s account value. That structural difference is exactly what makes the tax treatment different too.
What Does This Look Like in a Real Product?
Nationwide CareMatters Annuity is a clean example of a genuine 7702B-qualified structure. It’s a cash indemnity product — no bills or receipts required once a claim is approved — linked to a deferred annuity, and it’s specifically designed and filed as qualified long-term care coverage. Benefits are generally received tax-free each year up to the greater of the HIPAA per diem limit or your actual qualifying LTC costs, and a single deposit can be leveraged into two to three times the contract value in available LTC benefits, depending on the underwriting class.
By contrast, an income rider on a different annuity that includes an ADL-triggered payout increase — without that rider being separately structured as 7702B-qualified LTC coverage — doesn’t get that same treatment, even if the sales material uses very similar language about activities of daily living. In that case, the increased withdrawal is taxed the same way any other annuity distribution would be.
How Are Standard Annuity Distributions Actually Taxed?
This is where the two categories diverge most concretely. For non-qualified funds — money that’s already been taxed once, such as savings or a rollover from another non-qualified annuity — withdrawals are taxed on a Last-In, First-Out basis. That means the earnings in the contract come out, and get taxed, before any of your original principal does. Only once all the gain has been withdrawn does the tax-free return of principal begin. For qualified funds — an IRA or 401(k) rollover — the entire withdrawal is taxed as ordinary income, regardless of how much of it represents principal versus growth, the same as any other qualified distribution.
There’s a further wrinkle worth knowing about, even among income riders themselves: it depends on whether you’re withdrawing or annuitizing. A GLWB rider lets you take guaranteed lifetime withdrawals without ever annuitizing the contract — and those withdrawals get the LIFO, gains-first treatment described above. A different rider, a Guaranteed Minimum Income Benefit (GMIB), guarantees a minimum income level too, but you have to actually annuitize the contract to use it. Once annuitized, non-qualified payments switch to exclusion ratio treatment instead — each payment split between taxable gain and tax-free return of principal, based on your cost basis relative to your expected lifetime payout. Two riders that sound similar, solving a similar problem, and the tax treatment follows the mechanics of how the money actually comes out, not just what the rider is called.
Neither of these treatments is bad on its own — they’re simply the standard rules for annuity distributions generally, the same rules that would apply whether or not the withdrawal happened to be triggered by an ADL determination.
Does the Rider Fee Itself Affect My Taxes?
Generally, no — and this holds for both categories, with one notable exception. The annual charge an insurer deducts to pay for a rider is typically treated as a contract expense, not a taxable distribution to you, so paying it isn’t itself a taxable event. It also generally doesn’t increase your cost basis — meaning it doesn’t add to the amount you can later recover tax-free. The exception is a genuine tax-qualified LTC rider, where the charges generally do reduce your cost basis in the contract instead of simply being absorbed as a fee. That’s one more small but real difference between the two categories, on top of how the resulting benefit itself gets taxed.
How Do You Actually Tell the Two Apart?
Not by the name of the rider or how the brochure describes it. The reliable way is to ask directly whether the specific rider is structured and filed as a qualified long-term care insurance contract under 7702B, or whether it’s an income rider with a benefit enhancement that happens to use ADL criteria as its trigger. A carrier’s product illustration and disclosure documents should say so explicitly — and if it’s not clear from those materials, that itself is worth asking about directly before assuming either way.
Where Does Insurance Planning Fit In?
This distinction matters most when you’re comparing illustrations side by side, since the after-tax value of two products with similar-looking payouts can differ substantially depending on which category each one falls into. It’s exactly the kind of detail that’s easy to miss if you’re comparing headline numbers alone, and it’s exactly why your CPA or tax advisor should be looped in on the specifics of any product you’re seriously considering — not as a formality, but because the actual structure of the rider is what determines the tax outcome, not the marketing description.
What To Do Next
If you’re comparing annuity illustrations and want to understand exactly how a specific rider would actually be taxed, we’re glad to walk through the details with you and your tax advisor. Call us at (800) 927-9326 or email — no pressure, just straight answers.
By Marc Gilman, Gilman Agency
This information is general in nature and not intended as tax or legal advice. Product structures and tax treatment vary by carrier and contract, and are subject to change. Please work with your CPA or tax advisor to determine the specific tax treatment of any product before making a decision.
Sources: 26 U.S.C. § 7702B (Internal Revenue Code); Internal Revenue Code Section 72 (annuity distribution taxation); Internal Revenue Service, Publication 575 (Pension and Annuity Income); Nationwide Financial, Nationwide CareMatters Annuity product materials and client FAQ.
