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Implications of Cashing Out Life Insurance

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For many, it can seem like a simple solution to a large issue: families who are struggling to meet the high costs of long-term care or other medical bills would be able to sell unwanted life insurance policies and raise large amounts of money instead. However, going the route of a life-settlement arrangement can be a complex decision that should not be made alone or lightly. The market makes it difficult for sellers to know if they are actually getting the best price possible. There are also legal documents that need to be reviewed and can lead to potentially complicated tax implications based on the decision. Sellers need to keep in mind that potential buyers of their policy, as well as brokers or agents arranging the sale, are also looking to make money off of their “death” so to speak.

There’s also the question of whether the original reason for having the insurance is actually valid. At it’s basic level, a life settlement calls for the insured to sell his or her policy to a buyer, who would become responsible for paying the premiums. The buyer would be entitled to the death benefit when the individual dies. “You have to be comfortable with the idea that a stranger owns the insurance on your life,” says Philip Bouklas, an attorney in New York. In addition, many buyers prefer sellers who aren’t likely to be living long. “A healthy person who is in their 70s might not get as much as an ill person in their 60s,” says Mr. Bouklas.

For the seller, the advantage would come from getting a payment in exchange for the policy that is greater than the amount of cash-surrender value set by the insurance company. However, it can be a wake-up call to potential sellers to see just how little they’re likely to receive. A 2010 report on life settlements provided by the Government Accountability Office discovered that policyholders were paid around 13 percent to 21 percent of the face value of their insurance. Selling a policy is usually done through a broker who solicits bids from investors. Those brokers can also take a large commission, although their portion that they receive has been substantially lower lately. According to the GAO report, commissions dropped down to 9 percent in 2009 in comparison to the 15 percent that was available in 2006.

A seller “needs to know who they are dealing with,” says Jim Donelon, Louisiana insurance commissioner. “Make sure you check out the credibility of the company and the representative of the company” involved in the settlement. This can generally be done by contacting state insurance departments. Sellers should also factor in taxes. Life-settlement sales can be subject to both capital gains and ordinary income taxes. Before agreeing to any type of sale, a seller should take some time to discuss everything with their accountant to make sure it’s the right choice.