by Archie M. Richards, Jr.
December 25, 2006

You're over 65, and your cash-value life insurance policy continues to cost too much.

Life insurance you no longer need. Your children have flown the coop. Estate taxes have been reduced from when you acquired the policy. You want long term care insurance, whose premiums are expensive. You may want to enhance your lifestyle, fund your grandchildren's education, or make charitable gifts. But your family has no need for extra money after you die. You'd prefer to have more money now.

Here are possibilities for dealing with your policy. (This column has been approved by Brian Smith, of the Life Settlement Institute.)

1. Cash it in. This is probably the worst solution. If the premiums you've paid over the years exceed the cash value, which is likely, you take a loss that can't be deducted.

2. Exchange your policy for an annuity, preferably a variable annuity, in which you select stock mutual funds to achieve investment growth. The exchange is referred to as a "1035 exchange," named after Section 1035 of the IRS Code. The transaction is tax free. (I recommend Vanguard's low cost variable annuity.)

   The cash surrender value of the life policy is the cash invested in the annuity. Premium payments are no longer necessary, and you can begin receiving income from the annuity whenever you like.

   If the premiums you've paid on the life policy exceed the cash surrender value, the tax loss swings over to the annuity. The annuity can grow substantially before any of your withdrawals become taxable.

3. Sell your policy - probably the best of the three choices. The transaction is called a "life settlement." The buyer would likely be a financial institution, which would continue to pay the premiums and collect the death benefit at your death.

   You have to become accustomed to an institution profiting from your death. But your feelings are moderated by cash you receive up front. On average, the cash exceeds the policy's cash surrender value by 4.5 times.

   About 90 percent of life-settlement purchases involve universal life policies, including those that are underfunded. The buyer would provide the funding to make the policy viable. Other kinds of life policies also qualify.

   (About 90 percent of all universal life policies do not mature to a death claim. Life settlement is indeed a valid option.)

   To qualify for a life settlement, you should be at least 65, with a policy of at least $100,000 that you've held for at least two years. The chances of finding a buyer are improved if you've suffered some decline in health since the policy was issued.

   A buyer may not be available if your policy requires a big investment to properly fund it and you're in excellent health, meaning the buyer must continue paying premiums for a long time before receiving the death benefit.

   Large policies are often split, with a portion sold and the remainder retained. The portion sold should have a death benefit of at least $250,000.

   If the cash you receive is less than the total premiums you've paid into your policy, the life settlement is tax free. If the cash you receive exceeds the total premiums, the excess is taxed at favorable capital gains rates.

   To the person who finds a buyer for your policy, expect to pay a commission of about 10 percent.

   In 2005, over $10 billion of life policies were sold in life settlements. This includes a great many cash-value policies that probably shouldn't have been bought in the first place.

   Which leads to a word of advice for young married folks, most of whom do indeed need life insurance: Avoid policies that have cash values. Instead, buy inexpensive term insurance and invest the difference. (Be sure to invest the difference.)

   Later, when the insurance is no longer necessary, you won't need to bother with a 1035 exchange or a life settlement. Just stop paying the premiums. There's no insurance cash value to lose. The value is in the investments.