Shoud we take annuity payments for Mom's healthcare needs from the interest on her annuity or the principle?

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Sorry to say the answer is "it depends".

One issue is taxation. If the contract was issued prior to August 14, 1982 there may be an advantage to taking principal first as "FIFO" (First In - First Out) taxation of gain applied. What this means is that for such contracts the owner is permitted to withdraw tax-free principal first as opposed to "LIFO" (Last In - First Out) taxation which requires withdrawal of taxable gain first. This allows the owner to determine when it is best to pay taxes on the gain.

It may not be readily apparent that the policy is that old. Over the years, many annuity owners have exercised what is known as a “1035 exchange” which is a tax-free exchange of one policy for another. Policies exchanged this way will still qualify for the old tax rules.

The other issue is qualification for public benefits. If the annuity owner applies for Medicaid the cash surrender value of the annuity will be considered an available asset and must be "spent down" before benefit eligibility. If the policy is "annuitized" the asset is converted to an income stream and the asset "disappears".

The resulting income from the annuitization will be countable for Medicaid eligibility purposes and in the event the added income from the annuity puts the applicant over the income cap of $2,022 per month that situation is easily cured via the use of an "Irrevocable Qualified Income Trust".

In my opinion, annuitization only makes sense when the Medicaid beneficiary is in a Home and Community Based Waiver program and receiving care at home or in an assisted living facility as the excess annuity income can be used for cost of care. If the beneficiary is in a nursing home the annuity payments are essentially “wasted” as countable income and other planning techniques should be considered (unless there is a community spouse).

Caveat: If you want to annuitize the contract for Medicaid benefit eligibility be certain the policy is then a "Medicaid Qualified Annuity". Most companies do not have the terms in their contracts Medicaid requires and it may be necessary to surrender (cash in) the policy and then purchase the appropriate immediate annuity. You will need a professional to identify the correct policy.
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...not a financial wizard, but normally, for most assets, you want to perserve the principle. I hope someone who has a financial background chimes in.
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