When a parent needs long-term care, you start looking for money wherever you can find it. During your search, don’t overlook an old life insurance policy. Your parent may have bought a policy long ago to cover a mortgage or protect kids who are now grown up. If the original reason for the policy isn’t a factor, they may be able to sell the policy for cash while they’re still alive. That’s called a life settlement, and the cash can help pay for care.
However, selling life insurance to pay for long-term care can bring up tax, benefit, and fee questions that a sales pitch tends to skip. Here’s how it works and what to look into before you sign over a policy.
What is a life settlement?
In a life settlement, your parent sells their policy to a third party for a lump sum. The buyer pays more than the cash surrender value (what the insurance company would pay if your parent canceled the policy) but less than the death benefit. The buyer takes over the payments and collects the death benefit when your parent dies. Your parent can spend the money on anything, including care, home modifications, or paying down debt.
Who qualifies
Buyers want older sellers with shorter life expectancies. These are the typical requirements:
- Age: 65 or older. Younger sellers with a serious or chronic illness can qualify
- Face value: Your policy may need a face value of $100,000 or more.
- Policy age: The policy must have been active for anywhere from 25 months to five years, depending on the state.
- Policy type: permanent life insurance, or term insurance that converts to permanent coverage. A plain term policy with no conversion option usually won’t sell.
What your parent will get
Offers vary by the policyholder’s age and health, policy type, premium, and company. According to the Life Insurance Settlement Association, policyholders generally receive anywhere from 10% to 50% of the face value/death benefit when they sell a life insurance policy. But fees eat into the proceeds. Brokers typically charge 8% of the policy’s face amount or 30% of the payout.
Some providers advertise payouts of several times the cash surrender value. Ignore the multiples and compare written offers from at least three licensed providers after fees.
Taxes
A life settlement can create a tax bill. Your parent’s basis in the policy is typically the premiums they paid. Proceeds up to that basis are tax-free. But any gain up to the cash surrender value is taxable as ordinary income. Anything above that generally counts as capital gain, and typically qualifies for lower capital gains tax rates.
Early payouts from a policy’s own accelerated death benefit rider follow different rules. Those payouts are generally tax-free when a doctor certifies a life expectancy of 24 months or less. Work with your CPA or tax advisor to run the numbers before your parent accepts an offer.
Medicaid and other benefits
A large lump sum can push your parent over Medicaid and Supplemental Security Income limits. Medicaid also generally counts a policy’s cash surrender value as an asset, so the policy affects eligibility even if your parent never sells it. If your parent might need Medicaid soon, talk to an elder law attorney before selling.
Remember, you lose the death benefit
The sale ends the coverage. If your parent’s spouse or another family member needs that payout, a settlement might not be the right move. Make sure the surviving spouse and other dependents will be okay before you move forward.
Alternatives to selling life insurance to pay for long-term care
Selling a life insurance policy might not be your parent’s best move. Consider these alternatives:
- Accelerated death benefit or chronic illness rider. If your parent’s policy includes an accelerated death benefit or chronic illness rider, they may be able to draw part of the death benefit early. Just keep in mind that payments reduce what beneficiaries receive later.
- A 1035 exchange into a hybrid policy. The IRS allows tax-free exchanges of a life insurance policy for a hybrid policy that includes long-term care benefits. The exchange must go directly between the two insurers, and surrender charges may apply.
- Surrender, borrow, or reduce. Your parent can cash out the policy, borrow against the cash value, or convert to a smaller paid-up policy that stops the premiums.
How to bring it up with your parent
Money talks with parents are hard, and life insurance adds the awkwardness of discussing death. So start by stating your goal for the conversation. You can say something like, “I want to make sure we use the resources you’ve already paid for to cover your care.” Then gather these details:
- The insurance company and policy type
- The face value and current cash value
- The annual premium
- Any loans against the policy
- Any riders
- The beneficiaries
The insurance company can provide an in-force illustration and the latest statement. Getting a quote doesn’t commit your parent to a sale, but get that in writing before signing any broker paperwork.
