Retirement in America doesn’t come with a guarantee anymore. For many retirees, there is a growing uncertainty about their retirement and it is making them look closely at assets like life insurance policies as a way to pay for it.
The life insurance policies many seniors have paid into, often forgotten or misunderstood, have grown in importance as a potential income source that can make a difference once they retire. Retirees often hold these policies to pass on assets to heirs or to pay for estate taxes upon death, but, as needs change (and the estate tax exemption has been raised), the need for the policies can change too—especially when their costs rise.
The December surprise many seniors experience is just how expensive it can be to retire. Medical costs and the threat of the need for long term care have turned many seniors’ plans for retirement upside down, requiring them to find more assets than they originally thought they would need.
Selling a life insurance policy to companies in the secondary market has become a viable strategy for these retirees. According to the Employee Benefit Research Institute’s annual survey,1 confidence about having enough money in retirement has declined in part because of concerns about medical costs. The survey found that 44 percent of retirees said their healthcare expenses are higher than they expected when they first retired. If that includes long term care, costs have skyrocketed with the cost of a private nursing home room nearing $100,000 a year according to Genworth Financial.2
One of the responses to this feared shortfall in retirement has been to keep working beyond retirement. But, a Federal Reserve study3 found that while 38 percent of respondents said they planned to do that to make their retirement funds last longer, only seven percent actually did.
This makes the proper use of assets like life insurance all the more important. Life settlements have been around since 1911 when the Supreme Court ruled insurance policies could be bought and sold like other investments. The awareness of the ability to sell a policy to a third-party company has been slower to catch on; many holders have surrendered policies to the issuing insurance company for a lot less than the open-market value or they have simply stopped making premium payments.
The industry supporting sales of policies has grown to total $1.7 billion in policies sold in 2016 according to the Life Insurance Settlement Association. It has become a mainstream asset strategy that includes several options for policy owners and agents to turn what often is an unneeded death benefit into a living benefit for their immediate needs.
There are a variety of options policyholders can potentially access through the secondary market. They can use a policy to create a guaranteed income stream through the seamless exchange of their policy for an annuity, benefiting from the market value of the policy that can be five to eight times the surrender value.
The owner could also address the expensive costs of long term care by exchanging the policy for a Long Term Care Benefit Account, which the National Association of Insurance Commissioners cited in its July, 2017, paper Private Market Options for Financing Long-Term Care. This is a specific bank-trust account designed to make monthly payments to any form of senior living or long term care facility and does not require filing claims or completing any waiting period.
The policy owner could also elect to keep a reduced paid-up death benefit by exchanging the policy for a Retained Death Benefit without being responsible for any future premium payments. And, of course, the owner could elect to take a lump-sum cash payment in exchange for their policy that, on average, could be five to 10 times greater than any remaining cash surrender value.
While this strategy has been building as a trend among retirees and their advisors, several important tax changes have been made that make selling a life insurance policy even better:
- Tax Treatment of a Life Settlement. Tax treatment for a life settlement was revised in the Tax Cuts and Job Act of 2017 (TCJA).4 This tax provision from 2009 created a difference between the tax treatment for a policy owner when surrendering a life insurance policy versus settling a policy. The new ruling, retroactive to 2009, establishes that tax treatment for surrender value and a life settlement are on equal footing when calculating basis. Now a policy owner only pays capital gains tax based on the amount of funds realized beyond the owner’s basis in the policy.
- Estate Tax. Many large life insurance policies were purchased over the years as a wealth and legacy preservation strategy to offset the impact of estate taxes. Prior to the TCJA the estate tax threshold was $5,490,000, but starting in 2018 that number has been almost doubled to $10,000,000. With this increase, policies currently inforce to protect estates valued below this level may no be longer necessary. This means that life settlement may be an ideal exit strategy for a no longer needed policy. It may also be a chance for the policy owner to recoup some or all of their premium payments now under more advantageous tax conditions.
- Exemption from Federal Taxes. The IRS has ruled that a life settlement is exempt from federal taxes for a policyholder considered to be terminally or chronically ill.5 For a policy owner facing potentially high costs associated with severe healthcare or long term care needs, settling their policy may be a significant financial benefit during a time of need.
Footnotes:
- https://www.ebri.org/pdf/surveys/rcs/2018/RCS_18.FS-1_Confid.pdf.
- https://www.genworth.com/about-us/industry-expertise/cost-of-care.html.
- https://www.federalreserve.gov/2015-report-economic-well-being-us-households-201605.pdf .
- https://docs.house.gov/billsthisweek/20171218/CRPT-115HRPT-466.pdf .
- https://www.law.cornell.edu/uscode/text/26/101.
