What Happens When You Sell Your Life Insurance Policy?

Understanding Policy Sales

Selling a life insurance policy, known as a life settlement, involves transferring ownership to a third party for a cash sum. This payment is greater than the policy’s cash surrender value but less than the full death benefit. This arrangement provides a financial option for policyholders who no longer need or want their coverage.

Policyholders often sell their life insurance due to changes in personal or financial circumstances. Reasons include diminished need for coverage (e.g., grown children), high premium costs, or unexpected life changes requiring immediate funds (e.g., healthcare expenses, retirement planning).

Permanent life insurance policies, such as universal life, whole life, and variable universal life, are generally eligible for life settlements as they build cash value. Convertible term life policies may also qualify if converted to permanent. Term life policies without a conversion feature are typically ineligible.

Eligibility for a life settlement considers the insured and the policy. Most providers prefer insured individuals aged 65 or older, though younger individuals with significant health impairments may qualify. Policies usually need a face value of at least $100,000 to $250,000 and must have been in force for a minimum of two years, with some states requiring up to five years.

A life settlement differs from surrendering a policy. Surrendering means returning it to the insurer for its cash surrender value, which is often less than a life settlement. In a life settlement, a third-party investor buys the policy, assumes premium payments, and becomes the new beneficiary.

The Sale Process

The sale process begins by contacting a licensed life settlement provider or broker. A broker represents the policyholder, securing competitive offers. An initial assessment determines if the policy meets eligibility criteria.

Once eligibility is confirmed, the policyholder provides documents for evaluation. These include policy information (number, type, face amount, premium schedule) and medical records. Underwriters use medical records to assess health and estimate life expectancy, a key factor in determining the policy’s value.

After documentation submission, the provider or broker gathers offers from buyers. Offers are based on the insured’s life expectancy, death benefit, and future premium obligations. Policyholders evaluate bids and can negotiate terms, with no obligation to accept an unsatisfactory offer.

Upon offer acceptance, a formal closing package is prepared. This includes legal documents for transferring ownership and beneficiary rights to the purchasing entity. An escrow agent facilitates this, ensuring documents are executed and funds held securely. The agent verifies ownership change with the insurer before releasing payment.

The final step is payment of the agreed cash sum to the policyholder. This payment is typically made through the escrow account once policy ownership transfer is officially recorded by the insurance carrier. The entire process can take several weeks or months.

Financial and Tax Implications

The sale price of a life insurance policy in a life settlement is influenced by several financial and actuarial factors. These include the policy’s face value, future premiums required to keep the policy in force, and the insured’s life expectancy. A shorter life expectancy often translates to a higher offer, as the investor anticipates receiving the death benefit sooner. The policy’s cash surrender value, while less than the settlement amount, also plays a role in the valuation.

Understanding the tax implications of a life settlement is crucial for the policyholder. Under the Tax Cuts and Jobs Act of 2017, the cost basis of a life insurance policy for settlement purposes is defined as the cumulative premiums paid into the policy. This simplified definition can result in a more favorable tax outcome compared to prior regulations.

The proceeds from a life settlement are generally taxed in a three-tiered structure. The portion of the settlement proceeds equal to the policyholder’s cost basis (total premiums paid) is typically received tax-free. This amount represents a return of the policyholder’s original investment.

Any proceeds received above the cost basis, but up to the policy’s cash surrender value at the time of sale, are generally taxed as ordinary income. This portion is considered the accumulated earnings within the policy. The remaining proceeds, which are the amount received above the cash surrender value, are typically taxed as capital gains.

Policyholders should also consider potential state tax implications, as these can vary. Some states may tax capital gains as ordinary income, while others might offer preferential tax treatment for capital gains or impose no income taxes at all. Consulting with a qualified tax professional is advisable to understand the specific tax liability based on individual circumstances and state regulations.

Alternatives to Selling

For policyholders considering changes to their life insurance, several alternatives to selling the policy through a life settlement exist. One common option is to surrender the policy back to the issuing insurance company. This action terminates the coverage, and the policyholder receives the accumulated cash surrender value, if any. The payout from a surrender is typically less than a life settlement offer and often less than the total premiums paid.

Another alternative for policies with a cash value component is to take a policy loan. Policyholders can borrow against the accumulated cash value, providing access to funds without terminating the policy. Interest accrues on the loan, and any outstanding loan balance or interest will reduce the death benefit paid to beneficiaries. There is no set repayment schedule for these loans, as long as the policy remains in force.

Some life insurance policies include accelerated death benefit riders, which allow policyholders to access a portion of their death benefit while still living. This option is typically available if the insured is diagnosed with a terminal or chronic illness. The funds can be used to cover medical expenses or other needs, and the remaining death benefit is reduced accordingly.

Policyholders can also explore options to reduce their death benefit. Lowering the death benefit can lead to reduced premium payments, making the policy more affordable to maintain. This can be a suitable choice for those who still desire some level of coverage but are struggling with high premium costs.

In situations where a policy is no longer needed or affordable, allowing the policy to lapse is another possibility. This occurs when premium payments are stopped, and the policy terminates, usually without any payout unless there is sufficient cash value to sustain it for a period. This differs from a surrender where a specific cash value is received.