When it comes to life insurance, there's a variety of reasons why older Americans might wonder if they should let their policy lapse.
For instance, someone who put a policy in place before the estate tax exemption was raised this year — to about $11.2 million from $5.5 million per person — might no longer need the insurance to cover taxes. For others, maybe the premiums have become unaffordable or there's no one they want to leave the money to anymore.
Regardless of the cause, one option for an unwanted life insurance policy is to sell it. That's right: Get cash now from investors, who will get the death benefit when you die.
"It is a little weird … and it's a morbid conversation," said certified financial planner Ashley Foster, founder of Nxt:Gen Financial Planning in Houston. "But if someone is having trouble paying their premiums … or doesn't have an insurable need, it can sometimes make sense."
While the thought of strangers financially benefiting from your death might be creepy, selling a policy can be wiser than simply walking away from it or only getting the surrender value.
"It's an asset like any other," said CFP Barry Flagg, managing principal at Triangulum Financial Partners in Tampa. "If I had a mutual fund on my balance sheet and it didn't perform how I wanted it to, I wouldn't just give it back to the mutual fund company."
Here's the skinny on "life settlements."
The transaction basically involves a life-settlement company giving you cash in exchange for your policy. You no longer pay the premiums, and when you pass away, the death benefit goes to the investor who now owns it.
Generally speaking, if you're age 65 or older and your policy's death benefit is at least $100,000, it could have value to investors, according to the Life Insurance Settlement Association.
If you're worried that a Tony Soprano-like hitman will appear to free up that benefit quickly, there's little need to worry.
When you sell the policy, it gets held in a blind pool overseen by a financial institution other than the buyer. Additionally, your policy can only be resold as part of a larger transaction that includes other policies.
In other words, a layer of privacy is built into the deal.
Generally speaking, policies with a built-up cash value — i.e., universal or whole life policies — could be worth something to life-settlement investors.
Term-life policies that have the option to convert to permanent insurance also could be contenders.
Don't expect to get the face value of your policy: The settlement comes in somewhere above the cash value and below the death benefit. The exact offer depends on a variety of factors, including the premium amount, the cash value and whether there are any loans against the policy.
The amount also depends partly on your life expectancy, which in turn is based on your age and your health. The shorter the life expectancy, the larger the settlement.
While standard life insurance proceeds are untaxed — i.e., you die, your spouse gets the death benefit tax-free — life-settlements are treated differently by Uncle Sam.
For illustration purposes: Say you have a $500,000 policy. Over the years, you've paid $90,000 in premiums. Due to $60,000 in investment gains, the policy's cash value is $150,000.
You get a life settlement of $200,000. The $90,000 you paid in premiums comes back to you tax-free. The $60,000 difference between that and the cash value is taxed as ordinary income. The remaining $50,000 is taxed as a long-term capital gain.
(Note: This taxation is effective as of 2018. The Republican tax bill reversed 2009 Internal Revenue Service guidance that had changed the tax treatment of a portion of premiums paid.)
Keep in mind, too, that getting a big lump sum of cash in one year can push you into a higher tax bracket. And the higher your income, the more you'll pay in long-term capital gains taxes.
It's also important to comparison-shop. Flagg once worked with a client once whose broker presented her with only one offer. When Flagg asked the middleman to check with more life-settlement companies, a significantly better deal was found.
"It's an advisor's job to take the steps necessary to make sure the client can sell the policy for as high an amount as possible," said Flagg, whose company serves a sub-advisor to life insurance trusts.
If you work with a broker or advisor, make sure the person gets a complete list of purchase offers from all eligible buyers. Licensing of life-settlement companies is done at the state level, so you could check with your state's insurance department to see how many providers there are.
It's also possible to sell the policy while retaining some of the death benefit. For illustration purposes: Say you have a $1.5 million dollar policy and only need to leave $500,000 to your beneficiary. You sell the other $1 million in exchange for retaining that amount for your heir.
Remember, though, selling is only one option.
"If the premiums get burdensome but it makes sense to keep the policy for the death benefit, you could ask your beneficiaries to cover the premiums on the policy for you," said Forster at Nxt:Gen Financial Planning.