Financial advisors often recommend annuities for retirement income—for example, to solve for "longevity risk." But if clients or their spouses seek to qualify for Medicaid, they'd better be careful. Certain types of annuities can harm Medicaid eligibility, while others can actually be helpful.

"Medicaid rules include both asset limitations and income limitations," said Matt Zagula, an asset protection and tax advisor at Weirton, W.Va.-based Zagula Management. "Although annuities can be exceptionally beneficial [for] a retirement income plan ... for an older individual facing [long-term] care costs, the annuity will be viewed as a resource available for payment ... thereby making the applicant ineligible for Medicaid."

You might not be thinking about Medicaid for your clients, but it can be vital for helping pay for large, unexpected expenses, such as those incurred by long-term nursing home care, which can wipe out a nest egg in very little time.

The way annuities can help with Medicaid eligibility is that they can transform otherwise countable assets, such as savings accounts, into a non-countable income stream, thus protecting assets for heirs while spending down what counts against you in Medicaid eligibility.

Generally, the best type of annuity for this purpose is the Single Premium Immediate Annuity (SPIA). That's because SPIAs are the simplest, most transparent type of fixed annuity, with a lump-sum premium payment at the outset, and a predetermined, contracted payback schedule. In contrast, variable annuities invest in a range of securities that don't have guaranteed returns.

But Doug Chalgian, a certified elder law attorney at Chalgian and Tripp in East Lansing, Mich., recommended caution. "The use of annuities in Medicaid planning is a complicated topic," he said. "Certainly there is a long history of abuses by annuity salespeople with respect to marketing annuities—SPIAs in particular—for Medicaid eligibility purposes. At one time such annuities were treated more favorably. In 2006, federal law was revised to make the ability to benefit from these annuities even less beneficial [the Deficit Reduction Act (DRA) of 2005 introduced new rules to limit the transfer of assets for purposes of gaining Medicaid eligibility]. That said, there remain appropriate uses for SPIAs that fit with some Medicaid planning techniques."

In broad terms, to assist with Medicaid eligibility, a SPIA must SPIA must be "non-cancelable, non-assignable and actuarially sound," said Yale Hauptman, an attorney at Hauptman & Hauptman in Livingston, N.J., who specializes in elder, estate planning and special-needs law.

That means, first, that it must be irrevocable. The funds stay in the annuity, except for contracted monthly payments.

Second, the annuitant must receive back at least as much as was paid into the annuity during his or her actuarial life expectancy.

Third, if there is a guaranteed minimum number of payments, it must not exceed that actuarial life expectancy.

Finally, per the DRA, annuities must name the state as beneficiary for at least the value of the Medicaid assistance received (exceptions such as the presence of a disabled child may apply).

In other words, you can convert an asset into an income stream, but you can't change it back. What's more, the "income rules must be examined to determine if the additional income will be a problem or not," Hauptman added. "If the annuity can be converted to a lump sum or sold for a lump sum, Medicaid still treats it as an asset. That’s why most annuities don’t work for Medicaid purposes."

Clearly, the rules are structured to discourage the use of annuities such as a SPIA. "This is all designed to limit the use of this strategy by forcing the money to be paid out sooner and spent down, which is what the state wants you to do before asking it to pay for your care," said Hauptman. "The overriding principle of Medicaid’s financial eligibility and spend-down rules is that the State does not want to pay for your care until you have used all your funds first."

Moreover, the rules are not uniform nationwide. "Rules for long-term-care Medicaid benefits vary from state to state," said Chalgian.

It can get even more complicated. "Because of income limits for some programs, and income contribution rules for other programs, conversion of an asset to a stream of income is not always in the best interests of a person seeking Medicaid long-term-care benefits," Chalgian noted.

To be sure, using annuities to qualify for Medicaid benefits isn't a simple task. "There is great danger in attempting it and failing," warned Hauptman. "You could end up with the worst possible outcome. You won’t get Medicaid to cover the care, which then requires you to continue to pay the entire cost yourself. But then the Medicaid compliant annuity could lock you into an income stream that won’t give you enough to meet that cost."