Let's say you have a cash value or convertible term life insurance policy, but you really need the money now. Or, maybe you're finding it hard to keep paying the premiums.
Instead of just surrendering your policy to the insurance company for its current cash value, there's a way to get a better profit. You can sell your cash value or convertible term life insurance policy to a life settlement company.
Life settlements are rapidly gaining steam as a means of retirement funding. Older policyholders (usually age 65 and up) can trade in their policies for a lump sum of money that can be used to pay for retirement expenses such as long-term care.
What Is a Life Settlement?
Today's life settlements are descendants of the old viatical industry, in which an investment company would purchase the life insurance policy of a terminally ill person so that he or she could get money immediately to pay medical bills. But viatical settlements were largely unregulated and there was a great deal of fraud and abuse.
Current life settlements are much faster, more convenient and structured, and policy owners no longer have to be terminally ill in order to cash them in. They are an ideal way for policyholders who either no longer need life insurance coverage or can no longer afford to pay the premiums to surrender their policies and get the most bang for their buck.
The National Association of Insurance Commissioners Long-term Care subgroup released a report last year that listed life settlements as one of three main options for paying long-term care expenses, along with long-term care insurance and hybrid life insurance products that have accelerated benefit riders.
Life settlements now also allow for a partial policy surrender, where the policy owner retains some of the death benefit for a lesser amount of money. The amount of money that is received is based on the amount of the policy death benefit, the premiums already paid, the number of remaining premiums that have to be paid and the rate of return that the buyer will need to receive in order to purchase the policy. This amount will be less than the full death benefit, but more than the cash value – usually considerably more. Policies with higher premiums whose owners have a projected long life span are worth less than cheaper policies where the holder’s life span is projected to be shorter.
What's more, technology has made the whole process much faster. Felix Steinmeyer, cofounder and CEO of Mason Finance, a financial planning firm that specializes in life settlements, says, “It is now possible for customers to get an instant quote on what their policies are worth with the touch of a button. They used to have to supply reams of data and then wait for months to get this.”
The 2017 Tax Cuts and Jobs Act contains a clause that changed how the IRS calculates the taxable basis in life settlement transactions. The new law overturns IRS Rule 2009-13, enacted in 2009. This former rule required policyholders to reduce their tax basis by the “cost of insurance” charges that were paid over the life of the policy. This made it extremely difficult for sellers to accurately determine their basis, because many insurers could not or would not disclose this information.
The new rule mandates that life settlements will now be taxed using the same rules that apply when a policy is surrendered. The amount of premium that is recouped from the sale is treated as a tax-free return of principal. Any additional amount of money received from the sale up to the amount of the policy’s cash surrender value is treated as ordinary income, and any proceeds above that are usually taxed as capital gains.
The Bottom Line
A life settlement is an attractive alternative to surrendering or letting a policy lapse that is no longer needed or has become too expensive. A study by the U.S. Government Accountability Office (GAO) indicates that the average consumer received four to seven times more from a life settlement than he or she would have gotten by surrendering a policy. Consult your financial advisor for more information on these transactions and to find out whether you qualify.