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Life Insurance Cash-Out Options: A Retirement Planning Quiz

·12 min read

If you're like a lot of people, you probably have an old life insurance policy stuffed in the back of a desk drawer somewhere gathering dust. Did you know you could tap into that old policy in retirement or even possibly sell it for some much-needed cash?

Life insurance is an important risk-management and savings tool that can be used as part of the financial planning process. Generally, it is purchased for three reasons: First, as an estate planning tool to help with burial and funeral costs. Next, to protect the income of a spouse in the event that the policyholder dies prematurely. And finally, to set aside money for retirement.

As a result, life insurance is now owned by over 87 million U.S. households, to the tune of nearly $600 billion in premiums a year. However, how well do policyowners really understand what they've got and how to best use life insurance for their retirement needs?

A recent study in the Journal of Financial Planning shows that Americans scored less than 50% on questions about life insurance. One such area that Americans don't seem to "get" is what to do with a policy in retirement. However, life insurance can be tapped into during retirement or even sold on the secondary market to provide cash flow to help meet expenses and spending goals in retirement.

See how you do on this true/false quiz on life insurance strategies in retirement planning, written with guidance from Anne Long, Senior VP at Lighthouse Life and Jamie Mendelsohn, Executive Vice president at Ashar Group.

Written by Jamie Hopkins, Esq., LLM, MBA, CFP®, RICP®. He serves as Director of Retirement Research at Carson Wealth and is a finance professor of practice at Creighton University's Heider College of Business. His most recent book, "Rewirement: Rewiring The Way You Think About Retirement," details the behavioral finance issues that hold people back from a more financially secure retirement.

1: If you bought a life insurance policy years ago to protect your young children, but now those kids are in their 30s and doing fine without you, you are "stuck" with a policy you no longer need.

  1. True

  2. False

The correct answer is B. False

A life insurance policy provides loved ones and others protection through various stages in life. The policy can provide for retirement income to a surviving spouse. Cash value can also be accessed to supplement retirement income needs. But, if a policyowner no longer can afford the premiums or no longer needs a life insurance policy, it should be appraised -- just like any other property -- for its fair market value.

There are multiple ways that a policy can be turned into cash for retirement purposes. For example, a policy could be cashed out for the cash value (surrendered to the insurance company), or it could be 1035 exchanged to an annuity product to provide lifetime income. But, many times, the best option is to sell that policy for the fair market value determined through the appraisal -- a life settlement.

2: A life settlement of a life insurance contract is the amount of money a beneficiary receives from the insurance company when the insured passes away.

  1. True

  2. False

The correct answer is B. False

A life settlement is the sale of an existing life insurance policy to a third party for a value in excess of the policy's cash surrender value, but less than its face value, or death benefit.

At this point the policy remains in effect because the insured is still alive, so the death benefit is not paid yet. Instead, in a life settlement, the ownership changes and the original owner receives some money now rather than waiting for the death of the insured individual. The new owner is now in charge of making premium payments and assumes the right to collect the death benefit at the death of the insured.

3: A life settlement can be worth more than the cash surrender value of the policy.

  1. True

  2. False

The correct answer is A. True

Policyowners must receive, as a matter of law, an amount that is greater than the policy's cash surrender value and any accelerated death benefit available at the time of the sale to engage in a life settlement. If you cannot get more than the cash value, you would not sell the policy as a life settlement and instead surrender the policy or hold it to maturity. Really, every consumer needs to see if holding the policy till death makes sense, or whether cashing it in for the surrender value, letting the policy lapse, or engaging in a life settlement is their best option. There is no single right answer as the outcomes depends on each individual situation and cash flow need.

However, it is important to note that none of these options might be the true value from a tax perspective of the policy. With life settlements they often provide, on average, more than four times the policy's cash surrender value, according to government and university studies.

For example, let's say we have a 79-year-old male with an $800,000 death benefit in a Universal Life Insurance policy. The policy has a cash surrender value of $18,000 and annual projected premiums of $28,000 out to age 100. In this situation, according to an illustration provided by Anne Long at Lighthouse Life, the life settlement value would be $110,000.

4: If a policy qualifies for a life settlement, I'll receive 50% of the death benefit or higher.

  1. True

  2. False

The correct answer is B. False

Policies on average sell for 10%-40% of face amount. The policyholder's age, health and cost to carry the policy in the future influence the value the most. Policies rarely ever go for 50% of the death benefit and never go for more than the death benefit. Remember, a life settlement is really just the sale of an insurance policy (property) to a third party. As such, the third party needs to gauge the risk of the insured dying, ongoing requirements for premiums, and a discount rate to determine what they are willing to pay for it. Additionally, there can be fees associated with selling the policy. A broker can take a commission on the transaction, and other transaction costs can eat into the amount that makes it back to the seller.

5: The proceeds from a life settlement cannot be used to pay for anything other than the policyowner's own primary retirement expenses. That means spending on things such as a vacation home, a grandchild's college expenses or charitable contributions would be off-limits.

  1. True

  2. False

The correct answer is B. False

The net proceeds from the sale of a life insurance policy are unrestricted in how they can be used. Most often, the proceeds are used to fund retirement for seniors, as well as health care and long-term care expenses. If a policyowner wants to make charitable contributions it might be better to actually gift the entire policy. Some charities accept the donation of a life insurance policy.

As the valuation from a gift and tax perspective of a policy could be higher than the cash surrender value or the amount you could receive from a life settlement, it can make sense in some situations to outright gift a policy. Additionally, if you want to generate cash flow for things like home purchases or college expenses you can also tap into cash value or take a policy loan. Taking a policy loan is typically a non-taxable event at the time of the loan and doesn't usually impact student aid or show up on a FASFA form.

6: A life insurance policyowner does not need to get permission from the issuing life insurance carrier before selling their policy.

  1. True

  2. False

The correct answer is A. True

Life insurance is considered property, and it is a policyowner's property right to enter into the sale of their policy. All policies have a right of assignment in the contract, and the policyowner does not need the permission of the life insurance carrier that issued the policy. The insurance company must record the change in ownership resulting from the sale. A life settlement transaction is similar to selling a home.

It is best to contact a life insurance agent or financial adviser before selling the policy to see what your other options are. However, be aware that most insurance companies do not push sales to the secondary market because it keeps more policies in effect for longer than they typically planned for, messing up some of the insurance company's actuarial assumptions on lapse rates. As such, insurance companies have pushed back against the sale of policies on the secondary market.

7: Young and relatively healthy individuals, under the age of 50, who own life insurance are not good candidates for a life settlement.

  1. True

  2. False

The correct answer is A. True

While there are numerous ways to enter into a life settlement, the main two are a traditional life settlement where the insured is in reasonably good health, but likely over the age of 65 and has a policy with at least $100,000 of cash value. Second, a viatical life settlement is a type of life settlement when the insured is terminally ill and usually is selling the life insurance policy to help pay for medical bills and continued treatment. For young people under the age of 50, most likely they would benefit from keeping their policy in effect or surrendering it for cash value instead of engaging in a life settlement.

8: Only permanent life insurance policies (a policy that does not expire until the insured individual passes away) are eligible for a life settlement.

  1. True

  2. False

The correct answer is B. False

Both permanent (universal life and whole life) and term policies can qualify for a life settlement. However, it is more likely that a permanent life insurance policy has additional value and qualifies for a life settlement. But even term policies, which are temporary policies for a set number of years that have no savings aspect or cash value -- may qualify for a life settlement, especially if they are still eligible for a conversion to a permanent policy. Conversion options on most term policies expire at age 70 or 75.

Because term policies end at a certain point and have no cash value component, if you do nothing with the policy at the end of the term, the life insurance coverage will go away. However, the new premiums attached to a converted term policy might be too expensive for the owner to make. As such, it is worth looking at the secondary market to see if the policy has any value instead of just letting the term expire.

9: Receiving cash value from a life insurance policy or life settlement proceeds typically only creates a taxable event if the money received from the cash value withdrawal or the sale exceeds the policyowner's tax basis (what you paid in premiums).

  1. True

  2. False

The correct answer is A. True

Typically, a permanent life insurance policy will have some cash value and the owner can access the cash value up to his or her basis level in the policy without triggering taxable income. One of the benefits of many permanent life insurance policies is that the owner can access his or her cash value up to their basis without paying taxes on the withdrawals. If you access cash value above and beyond your basis amount, that amount would be subject to ordinary income taxes as it is gain.

Additionally, the sale of a life insurance policy for less than your basis (premium paid) in the policy will likely not result in any taxable income. The Tax Cuts and Jobs Act of 2017 specifically addressed how federal taxes are computed on the proceeds of life settlement transactions. Proceeds are only taxable if they are greater than the tax basis, which is no longer reduced after TCJA for the cost of having insurance over the years. This was a benefit to policy owners who want to sell their policies as it allows for a higher basis at the time of sale, meaning potentially lower taxable income.

10: The underwriting process an insurance company takes before selling you a new life insurance policy is the same underwriting process that will occur when you try to sell an existing life insurance policy through a life settlement.

  1. True

  2. False

The correct answer is B. False

The underwriting process for buying a new life insurance policy is much stricter and more detailed than the process is when selling an existing policy as a life settlement. When buying a policy, the insurance company looks at a lot of factors, including age, gender, smoking, health and really anything related to mortality risk (the reasons an insured may pass away soon). Really the insurance company is trying to make sure you will live a long time and they won't have to make a payment soon. But the opposite is happening when you sell a policy to the secondary market. The secondary market for life settlements looks at longevity risk -- reasons an insured might live longer and then the buyer of the policy might not receive the proceeds soon.

So, generally speaking, when you are buying life insurance you need to have a long life ahead of you and when you are selling a policy you need to have a shorter time period left.

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