Selling an Insurance Policy for Cash

Q. I have AIDS and am thinking of selling my individual and group life insurance policies to generate money on which to live comfortably for the rest of my life. What kind of taxes will I have to pay on the money I get from these policies?-- M.W .

A. As more and more people with life-threatening illnesses seek to cash in their life insurance policies to raise cash to see them through their final days, an entire industry has sprung up around these so-called viatical settlements. Before you worry about tax consequences, however, you might wish to consider some other important issues in deciding whether this is the right move for you.

First, some background. All types of life insurance policies are eligible for such sales--whole life, term, universal and even group life from an employer. Selling one’s insurance policy usually takes six to eight weeks.

In general, the amount paid in advance on life insurance policies is between 50% and 80% of the policy’s face value. The percentage is lowest for small policies. Another factor is the policyholder’s life expectancy; the longer it is, the less you can expect to get for the policy.

Generally speaking, companies that buy these policies are looking for people who are expected to live less than two more years. They also want policies that are at least 2 years old, to ensure that the contest period on the policy has expired. Attempts to sell a policy during its first two years could trigger an investigation that might lead to losing the coverage entirely, due to misrepresentations on the original application.

Currently, proceeds from insurance policy sales are subject to regular federal income tax, but they are not taxed by the state of California. Some companies may try to imply that you have no tax obligation by telling you there is no reporting of the payment to the Internal Revenue Service on a 1099 statement or other document. While it is true that there is no formal reporting system, your tax obligation still stands. The federal government is considering allowing life insurance policies to be redeemed without tax liability by people who have life-threatening illnesses. However, the new regulations are not yet in effect, and when they are it is possible that they will apply only to policy sales made thereafter.

California requires viatical settlement companies to be licensed by its Department of Insurance. So far, about 30 companies have applied, and three have been licensed. Be sure you deal with a licensed company or one that has applied for a license and paid the required fees.

Be sure, too, that you secure at least three bids for a net cash-out value (after all expenses) and do not, under any circumstances, accept partial or installment payments.

Before selling your policy, ask your insurance company whether it offers an accelerated benefits program or will make you a loan against your policy. Many companies will advance you some of the proceeds during your lifetime, with the remainder to be paid to your beneficiary upon death. However, this service typically is available only to people who are expected to survive less than a year or even six months. Some companies will structure the payment as a loan so that no tax will be due.

Even if you expect to live longer than a year, you may be able to borrow against your policy, which would get you some of the money you need without the immediate tax consequences of selling.

For more information about viatical settlements, including a list of companies licensed or awaiting licensure in California, contact AIDS Project Los Angeles at (213) 993-1473 or (213) 993-1474.

Primers for New Investors

Q. I am 17 years old and have just come into an inheritance that I would like to invest. Are there some books you can recommend that I, or any beginner, would find easy to understand?-- J.P .

A. Peter Lynch, the former whiz-kid manager of the Fidelity Magellan mutual fund, has written two books with John Rothschild that are among the best in the field. One is “One Up on Wall Street”; the other is “Beating the Street.” Both books describe the ins and outs of savvy stock picking and offer tips on how to select companies and mutual funds that fit your investment objectives.

A third good choice is John C. Bogle’s new book, “Bogle on Mutual Funds: New Perspectives for the Intelligent Investor.” All three titles should be readily available from public libraries and bookstores.

Figuring the Value of Spun-Off Shares

Q. How do I know the tax basis of shares of stock that I have gotten when a company spins off one of its subsidiaries? I purchased Pacific Telesis stock years ago and received one share of its cellular subsidiary, AirTouch, and one share of its phone company operations for each share of stock I held. When I sell, what value do I assign to each of these new shares?-- J.L .

A. You should have received a letter from Pacific Telesis explaining this in detail. All companies spinning off subsidiaries and offering their shareholders new stock explain how the shares should be valued for tax purposes.

According to Pacific Telesis officials, you should first research exactly how much you paid for your original Telesis shares. Then you should assign 60.17% of that amount to the new Telesis shares and 39.83% to the AirTouch shares you received.

This information is also available from the investor relations office of the company in which you hold shares. It is also in the “Capital Changes Report” published by Commerce Clearing House, a book most brokerages should have on hand.