What is a Pension Protection Act (PPA) Annuity
What is a Pension Protection Act (PPA) Annuity
Jason Stolz CLTC, CRPC, DIA, CAA
The Pension Protection Act (PPA) of 2006 — which took effect for long-term care purposes beginning January 1, 2010 — is one of the most powerful and least utilized tools in retirement tax planning. It created a specific legal pathway that allows owners of non-qualified annuities to redirect the gains inside those annuities — gains that would otherwise be taxable as ordinary income when withdrawn — into long-term care insurance benefits that are received completely income-tax-free. For the right person in the right situation, a PPA annuity strategy does something that virtually no other financial move can accomplish: it permanently eliminates a deferred tax liability on existing annuity gains while simultaneously funding the long-term care protection that Medicare won’t cover and that most retirees eventually need.
Understanding how this works requires understanding three interconnected concepts: what a non-qualified annuity’s tax problem actually is, what a Section 1035 Exchange allows, and what the PPA specifically changed. Put together, they form a planning strategy that is especially compelling for people who own an older non-qualified annuity with significant built-in gains and have not yet addressed their long-term care exposure. At Diversified Insurance Brokers, we help clients evaluate whether a PPA annuity strategy fits their specific financial picture — and compare the available hybrid annuity/LTC products against traditional long-term care options across more than 100 carriers. Our long-term care insurance services overview provides foundational context, and our lifetime income planning resource explains how LTC planning integrates with retirement income strategy more broadly.
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The Tax Problem Inside Your Non-Qualified Annuity
A non-qualified annuity is an annuity purchased with after-tax dollars — money that was already taxed before it went into the contract. The original investment (called the cost basis) is not taxable when withdrawn, because it has already been taxed. But the gains — the interest, growth, and earnings that have accumulated inside the annuity over years or decades of tax-deferred growth — are taxable as ordinary income when withdrawn. This is the deferred tax liability that every non-qualified annuity owner with significant growth carries on their balance sheet, whether they think about it in those terms or not.
For a concrete example: a person who invested $75,000 in a non-qualified annuity 20 years ago and watched it grow to $175,000 has $100,000 in unrealized gains sitting inside the contract. The moment those gains are withdrawn — whether to pay for long-term care, for living expenses, or for any other purpose — they become ordinary taxable income. Depending on the owner’s tax bracket, that $100,000 could generate $22,000 to $37,000 in federal income tax liability. State income tax may add more. The annuity that appeared to be worth $175,000 is functionally worth considerably less the moment those gains are accessed — and for the retiree who needs to use annuity money to cover long-term care costs at exactly the point when income is tightest and medical expenses are highest, that tax hit is a genuinely painful outcome.
This tax problem does not go away at death. Unlike many other assets, annuities do not receive a step-up in cost basis when they pass to heirs — the deferred gain remains taxable to the beneficiary who inherits the contract. The PPA provides the only mechanism that allows this deferred gain to be permanently eliminated rather than merely deferred further.
What a Section 1035 Exchange Is and What the PPA Changed
Section 1035 of the Internal Revenue Code has long allowed a tax-free exchange of one insurance or annuity contract for another — specifically so that policyholders could move to better or more suitable products without triggering a taxable event on accumulated gains. A 1035 exchange from one annuity to another annuity defers the gain — it doesn’t eliminate it, it just moves it to the new contract. The tax obligation follows the money into the new contract and remains outstanding until withdrawal.
What the Pension Protection Act of 2006 specifically changed — in a provision that took effect January 1, 2010 — is that it expanded Section 1035 to allow exchanges from a non-qualified annuity directly into a tax-qualified long-term care insurance policy. This was new. Before the PPA, there was no mechanism that allowed an annuity gain to be anything other than taxable at withdrawal. After the PPA, there is a specific pathway: exchange the annuity gain into a qualifying LTC policy through a properly structured 1035 exchange, and those gains are never taxed — not on the exchange, not when LTC benefits are received, and not at death if benefits are unused and a death benefit passes to heirs. The gain is permanently extinguished as a tax liability.
The critical mechanism is that qualifying LTC insurance benefits — paid from a tax-qualified policy — are received income-tax-free under IRC Section 7702B. So when the deferred annuity gain is redirected through a properly structured 1035 exchange into a qualifying LTC contract, and then paid out as LTC benefits, those benefits are tax-free. The gain that would have been fully taxable as ordinary income is converted into tax-free LTC benefits. This is what makes the PPA annuity strategy genuinely powerful — it is not a deferral, it is a permanent elimination of the deferred tax liability on annuity gains, accomplished while simultaneously funding meaningful long-term care protection.
The Tax Comparison: Doing Nothing vs. a PPA Strategy
The table below illustrates the tax difference between using an existing non-qualified annuity for long-term care expenses without a PPA exchange versus using a properly structured PPA exchange. This example uses a hypothetical annuity with $75,000 cost basis and $175,000 current value — $100,000 in deferred gains. The owner is in the 24% federal income tax bracket.
original investment
$75,000
current value
$175,000
deferred gain
$100,000
tax bracket
24%
Scenario A: do nothing
Withdraw annuity gains to pay LTC costs directly
Scenario B: 1035 PPA exchange
Exchange into qualifying LTC annuity via Section 1035
In this example, the PPA strategy preserves $24,000 in federal tax savings — funds that stay available for care rather than going to the IRS. At higher brackets (32%, 37%) or with larger gains, the preserved amount grows significantly.
The Three Ways to Structure a PPA Annuity Strategy
The Pension Protection Act created flexibility in how the strategy is executed. Not every situation calls for the same approach — and the right structure depends on the size of the existing annuity, the amount of gain built up, the LTC product available, and the owner’s liquidity needs going forward.
Full 1035 Exchange — Annuity to Hybrid LTC Annuity. The most straightforward structure: the entire non-qualified annuity is exchanged directly into a hybrid annuity that includes LTC benefits. The new product continues to grow and accumulate, but all LTC benefit withdrawals are received income-tax-free under the PPA rules. This approach is best suited when the owner wants to repurpose the entire annuity for LTC planning and does not need to preserve the original annuity’s income stream. The hybrid product typically provides a leveraged LTC benefit — meaning the LTC pool available for care is larger than the premium paid — while also providing a death benefit if care is never needed.
Partial 1035 Exchange — Systematic Annual Premium Funding. When the owner wants to retain most of their existing annuity but redirect a portion annually to fund LTC coverage, a partial 1035 exchange is used. Each year, a portion of the annuity — drawn from the gain first, under LIFO (last in, first out) accounting rules — is transferred directly from the annuity to the LTC insurance company as a premium payment. Because the funds go directly from the annuity to the insurance company without the owner taking constructive receipt, the transfer qualifies under Section 1035 as tax-free. This is the approach best suited for funding ongoing traditional LTC insurance premiums from a gain-laden annuity. It is essential that the LTC insurance company accept the funds as a direct 1035 exchange — if the annuity owner first withdraws the money and then pays the premium, the favorable tax treatment does not apply.
Immediate Annuity to LTC Premium Funding. A third approach involves converting a non-qualified annuity into an immediate annuity and directing the income stream — specifically the interest component, which would otherwise be taxable — toward LTC insurance premiums. Because immediate annuity payments consist of both principal and interest, the interest portion used to fund the LTC premium can receive favorable tax treatment when structured properly. In some product structures, the annuity and the LTC coverage can be bundled from the same carrier, simplifying the administration.
Who This Strategy Is Best Suited For
The PPA annuity strategy is not universal — it is compelling for people in a specific financial position where the stars align between existing assets, tax exposure, and unaddressed LTC need. It tends to work best when several conditions are present simultaneously.
The candidate has a non-qualified annuity with meaningful unrealized gains — the larger the built-in gain, the more federal income tax the PPA strategy eliminates, and therefore the more compelling the economics. An annuity purchased 15 to 25 years ago that has grown substantially is the ideal starting point. The annuity is no longer actively needed for its original purpose — either the original income objective has been addressed through other retirement income sources, the annuity has been sitting idle, or the death benefit it would pass to heirs is less important than the LTC coverage it could fund. The owner has not yet established long-term care coverage — and rather than paying LTC premiums out-of-pocket from taxable income, the PPA strategy allows existing annuity gains to do that work without the tax hit. And the owner is in a moderate to high tax bracket — the higher the ordinary income tax rate, the more valuable the elimination of gain taxation becomes.
For people in their 60s and early 70s in good enough health to qualify for LTC coverage, this is often the most compelling window: old enough to have accumulated significant annuity gains, young enough to qualify for favorable LTC underwriting, and close enough to potential LTC need that addressing it now is genuinely urgent. Our resource on long-term care insurance explains how LTC underwriting works and what health factors affect eligibility.
LTC Annuities for People Who Are Already Older or Have Health Issues
A significant advantage of the hybrid annuity/LTC structure — compared to standalone traditional LTC insurance — is that annuity-based LTC products typically have more flexible underwriting requirements. Traditional LTC insurance can be difficult or impossible to obtain for people with significant health histories, and the underwriting becomes more challenging as age increases. Some hybrid annuity/LTC products use simplified or guaranteed-issue underwriting that does not require the detailed medical questionnaires and possible decline risk of traditional LTC underwriting.
For individuals in their late 70s and 80s who have missed the traditional LTC planning window, annuity-based LTC solutions may represent the only viable path to establishing meaningful care coverage with favorable tax treatment. Our dedicated resource on long-term care insurance for seniors over 80 specifically addresses the product options available at older ages when traditional LTC insurance underwriting is no longer accessible, and how annuity-based solutions often fill the gap. These products are specifically designed for the planning reality that many people arrive at LTC awareness only when they or a spouse have begun experiencing health changes — and at that stage, the PPA annuity strategy may be the most powerful remaining tool available. Our LTC annuity resource provides detailed product education on how these hybrid structures work in practice.
Critical Rules: What Must Happen for the Tax Treatment to Apply
The tax-free treatment under the PPA is not automatic — it requires that specific procedural requirements be met. Several rules are non-negotiable and working with an experienced Long Term Care Broker and an experienced Annuity Broker is critical.
Direct transfer only. The funds must be transferred directly from the existing annuity or life insurance company to the new LTC policy — the annuity owner must never take constructive receipt of the funds. If the annuity owner withdraws money and then uses those funds to pay an LTC premium, the favorable 1035 exchange tax treatment does not apply. The gain becomes taxable at the moment of withdrawal, and the PPA benefit is permanently lost for those dollars.
The receiving policy must be a tax-qualified LTC policy. The LTC insurance contract receiving the funds must qualify under IRC Section 7702B — which most modern long-term care insurance policies do, but which should be confirmed before the exchange is initiated.
The source must be a non-qualified annuity or life insurance policy. The PPA 1035 exchange rules apply to non-qualified policies — those funded with after-tax dollars. Qualified annuities (those held in IRAs, 401(k)s, or other tax-qualified accounts) follow different rules and are not eligible for this exchange strategy.
The LTC company must be able to accept the 1035 exchange. Not all LTC insurance companies have the operational infrastructure to properly process a 1035 exchange from an annuity. The company must obtain the funds directly from the annuity carrier in compliance with 1035 rules. Working with an advisor who knows which carriers accept 1035 exchanges and which do not is essential to avoid structuring the transaction in a way that inadvertently triggers taxation.
Surrender charges may apply. If the existing annuity is still within its surrender charge period, the portion exchanged may be subject to surrender charges that reduce the amount available for the exchange. The free withdrawal provision of the annuity may limit how much can be exchanged annually without penalty. For partial annual exchanges to fund LTC premiums, the annual exchange amount should typically not exceed the annuity’s free withdrawal provision to avoid triggering surrender charges on the exchanged amount.
The Death Benefit Advantage: What Happens If LTC Is Never Needed
One of the most significant advantages of hybrid annuity/LTC products compared to traditional standalone LTC insurance is what happens to the money if long-term care is never needed. With traditional LTC insurance, premiums that are never used for care benefits are simply lost — the “use it or lose it” dynamic that many people find psychologically difficult when evaluating whether to purchase LTC coverage.
With a hybrid annuity/LTC product funded through a PPA 1035 exchange, there is typically a death benefit component: if the insured never needs long-term care, the policy’s residual value passes to named beneficiaries — and under the PPA and IRC Section 7702B rules, this death benefit may pass income-tax-free. This eliminates the specific tax problem that the original non-qualified annuity created: rather than passing a gain-laden annuity to heirs who inherit the deferred tax liability, the hybrid structure converts that gain into a death benefit that passes tax-free. The heir receives a benefit rather than a tax bill. This is one of the most compelling multi-generational planning dimensions of the PPA strategy — it addresses LTC exposure, eliminates deferred tax liability, and improves the after-tax legacy outcome simultaneously. Our resource on annuity beneficiary death benefits explains how death benefits are structured in annuity contracts and how they interact with estate planning objectives.
How This Fits Into a Broader Retirement Income Plan
The PPA annuity strategy does not exist in isolation — it is most powerful when it is coordinated with the full picture of retirement income planning. Several coordination considerations are especially important.
Social Security timing affects the context for LTC planning in meaningful ways. A person who delays Social Security benefits to age 70 to maximize the guaranteed lifetime income stream may find that the Social Security income, combined with any pension income and other annuity income, is sufficient to cover essential living expenses — which means an existing non-qualified annuity with significant gains is genuinely idle and is a natural candidate for conversion to LTC coverage. Our resource on delayed retirement credits and Social Security payout increases explains how the timing decision affects lifetime guaranteed income in ways that directly affect the role of other retirement assets.
For people building retirement income from multiple annuity sources, the LTC annuity funded through a PPA exchange represents a specific layer of the income plan — the care funding layer — that operates separately from the retirement income stream. A thoughtfully designed retirement income architecture may include a fixed or indexed annuity for guaranteed income, a MYGA for conservative accumulation, and a hybrid LTC annuity for care funding — each product serving a specific function within the broader plan. Our lifetime income planning resource explains how these layers work together, and our annuities hub provides education on each product type within the full annuity menu.
Finally, for people who already have an annuity and want an independent evaluation of whether a PPA exchange makes sense relative to their current position, our annuity second opinion service provides a carrier-neutral review that evaluates both the tax mechanics and the product options available for a PPA exchange in the current marketplace. The right product comparison — evaluating which hybrid annuity/LTC structure provides the best combination of LTC benefit, accumulation, and death benefit relative to the specific exchange amount — requires access to the full market of available hybrid products, which is exactly what an independent broker comparison provides.
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FAQs: Pension Protection Act (PPA) Annuity
What exactly is a PPA annuity and how does it differ from a regular annuity?
A PPA annuity is a hybrid annuity product that includes long-term care benefits and qualifies for the special tax treatment created by the Pension Protection Act of 2006 (effective January 1, 2010). The term “PPA annuity” is shorthand for an annuity structured to receive the PPA’s favorable tax provisions — specifically, the ability to pay LTC-related withdrawals income-tax-free, even when those withdrawals include gains that would normally be taxable as ordinary income.
A regular non-qualified annuity continues to grow tax-deferred, but any gains withdrawn — whether for living expenses, medical costs, or long-term care costs — are taxable as ordinary income in the year received. A PPA-qualified hybrid annuity’s LTC withdrawals are received completely tax-free under IRC Section 7702B, regardless of how much gain has accumulated inside the contract. The practical effect is that the PPA annuity converts taxable annuity gains into tax-free care dollars. Our LTC annuity resource explains how these hybrid products are structured in practice.
What is a Section 1035 Exchange and why does it matter for the PPA strategy?
Section 1035 of the Internal Revenue Code allows tax-free transfers between insurance and annuity contracts — specifically so that policyholders can move to better-suited products without triggering a taxable event on accumulated gains. Before the PPA, 1035 exchanges allowed you to exchange one annuity for another annuity (deferring the gain) or one life insurance policy for another. The gain moved with the money but was not taxed on the exchange.
The Pension Protection Act expanded Section 1035 to allow exchanges from non-qualified annuities and life insurance directly into tax-qualified long-term care insurance policies. This is what makes the PPA strategy genuinely powerful — it is not merely a deferral. When the annuity gain is exchanged into a qualifying LTC contract and subsequently paid out as LTC benefits, those benefits are tax-free under Section 7702B. The gain that would have been ordinary taxable income is permanently converted into tax-free care benefits. The tax liability doesn’t get deferred further — it gets permanently eliminated, which is something that almost no other financial planning mechanism allows for a gain already sitting inside a non-qualified annuity.
Does the annuity gain disappear if I do a 1035 exchange into an LTC policy?
Yes — when done correctly, the deferred gain that would have been taxable is permanently eliminated as a tax liability. Here is how it works: when you execute a proper 1035 exchange from your non-qualified annuity into a qualifying LTC contract, the exchange itself triggers no tax. The gain moves into the new contract. When LTC benefits are paid from the qualifying contract, those payments are received income-tax-free under IRC Section 7702B. If the LTC benefits are never used and the policy pays a death benefit to your heirs, that death benefit also passes income-tax-free — unlike the non-qualified annuity you started with, which would have passed to heirs with the deferred gain still taxable to them (with no step-up in basis). The result is that the gain inside a non-qualified annuity — which was going to be taxed at ordinary income rates at some point, whether at withdrawal by you or at inheritance by your heirs — is permanently converted into tax-free benefits. That is the most precise description of what the PPA accomplishes.
Can I do a partial 1035 exchange instead of exchanging the entire annuity?
Yes — and for many people a partial exchange is the more appropriate structure. A partial 1035 exchange allows you to redirect a portion of your existing annuity annually to fund LTC insurance premiums, while retaining the remainder of the annuity for its original income or accumulation purposes. The portion exchanged typically comes from the gain first (under LIFO accounting), meaning the most tax-inefficient portion of the annuity — the gains that would be fully taxable at withdrawal — is redirected to the LTC premium on a tax-free basis.
The critical operational requirement is that the funds must go directly from the annuity company to the LTC insurance company — the annuity owner must never take constructive receipt of the funds. If you withdraw from the annuity and then pay the LTC premium separately, the favorable 1035 exchange tax treatment is permanently lost for those dollars. Working with a knowledgeable advisor who coordinates the direct transfer between companies is essential to ensure the exchange is executed correctly. The amount exchangeable annually without surrender charges is typically limited to the annuity’s free withdrawal provision — usually 10% of account value per year. Our resource on annuity free withdrawal rules explains how this provision works in practice.
What if I am in my late 70s or 80s — can I still benefit from a PPA annuity strategy?
Yes — and in many cases, older individuals with existing non-qualified annuities are among the most compelling candidates for a PPA exchange strategy. The older someone is, the more likely they are to have an older annuity with substantial built-in gains from decades of tax-deferred growth. And the older someone is, the more immediately relevant LTC planning becomes — the probability of needing care in the next 5 to 15 years is meaningfully higher at 78 than at 58.
One important advantage of hybrid annuity/LTC products over traditional standalone LTC insurance is more flexible underwriting. Traditional LTC insurance underwriting becomes increasingly difficult to qualify for as age increases and health history accumulates — many people find at 75 or 80 that traditional LTC insurance is unavailable to them. Hybrid annuity/LTC products often use simplified underwriting or in some cases guaranteed-issue structures that do not require the detailed health qualification that traditional LTC insurance demands. This means a PPA exchange strategy may be available to older individuals who have missed the traditional LTC insurance window entirely. Our dedicated resource on long-term care insurance for seniors over 80 specifically addresses what product options remain available at older ages and how annuity-based LTC solutions often fill the gap when other options have closed.
What happens to the money if I exchange into a hybrid LTC annuity but never need long-term care?
This is one of the most important distinctions between a hybrid annuity/LTC product and traditional standalone LTC insurance. With traditional LTC insurance, premiums that are never used for care benefits are lost — the “use it or lose it” dynamic that makes many people reluctant to purchase standalone coverage. With a hybrid annuity/LTC product, there is typically a death benefit component: if the insured never needs long-term care or passes away before exhausting LTC benefits, the remaining contract value or a specified death benefit passes to named beneficiaries.
Under the PPA and IRC Section 7702B rules, this death benefit may pass income-tax-free to heirs. This is a particularly powerful outcome compared to the original non-qualified annuity situation: if you had done nothing and the annuity passed to your heirs at death, they would inherit the deferred gain as ordinary taxable income (no step-up in basis for annuities). By converting the annuity through a PPA exchange into a hybrid product with a tax-free death benefit, you eliminate that inherited tax liability entirely. Our resource on annuity beneficiary death benefits explains how death benefits are structured in annuity contracts and how they interact with estate planning objectives.
About the Author:
Jason Stolz, CLTC, CRPC, DIA, CAA and Chief Underwriter at Diversified Insurance Brokers (NPN 20471358), is a senior insurance and retirement professional with more than two decades of real-world experience helping individuals, families, and business owners protect their income, assets, and long-term financial stability. As a long-time partner of the nationally licensed independent agency Diversified Insurance Brokers, Jason provides trusted guidance across multiple specialties—including fixed and indexed annuities, long-term care planning, personal and business disability insurance, life insurance solutions, Group Health, and short-term health coverage. Diversified Insurance Brokers maintains active contracts with over 100 highly rated insurance carriers, ensuring clients have access to a broad and competitive marketplace.
His practical, education-first approach has earned recognition in publications such as VoyageATL, highlighting his commitment to financial clarity and client-focused planning. Drawing on deep product knowledge and years of hands-on field experience, Jason helps clients evaluate carriers, compare strategies, and build retirement and protection plans that are both secure and cost-efficient. Visitors who want to explore current annuity rates and compare options across multiple insurers can also use this annuity quote and comparison tool.
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