Sell your life to a stranger

Questions to ask yourself

Do I still need the insurance? If you're 65 or older, or if you have health issues, you may be unable to replace the insurance (or unable to afford to). So think about why you got the policy in the first place.

"Remember that you bought it to meet a certain need -- family planning, estate planning, business -- and make sure that the need truly is gone," says Mark Johannessen, a financial planner in McLean, Va., and a former president of the Financial Planning Association. If you still have a mortgage in retirement or are supporting or educating children or grandchildren, you should probably keep the insurance.

• Calculator: What is your life expectancy?

What's the net payout? The key is what you'll keep after taxes. A life settlement is the sale of an asset, a taxable event.

Most sellers make a three-tiered tax calculation: First, you don't owe taxes on the premiums you've paid through the years (minus any outstanding policy loans). Second, you owe ordinary income taxes on the difference between premiums paid (your basis) and the cash value. Third (and this is the big break), you pay capital gains on the amount by which the payout exceeds the cash value -- which is likely to be most of the haul.

If you have any questions about these tiers, consult a tax attorney. Knowing how big a bite the IRS would take is a major factor in determining the best settlement.

Is there a way to save on the cost of insurance? If you need insurance in old age but can no longer afford it, you may have options other than a settlement. Universal life, for example, has built-in flexibility in what you pay, says Glenn Daily, a fee-only insurance consultant in New York.

"A lot of people don't understand that they can change their premium," Daily says. If you have ample cash value, you may be able to skip or reduce your premiums for a while without danger that the policy will lapse.

Would a policy loan work instead? Life-settlement brokers focus on two numbers: the amount you'd get if you surrendered the policy to the insurance company and the substantially higher payout from a settlement. But those aren't your only options. If you need cash and want to keep the insurance in effect, you can take out a policy loan up to almost the amount of the cash value.

• Calculator: Do you have enough life insurance?

You won't get nearly as much as in a life settlement, but your beneficiaries will still get the bulk of the death benefit tax-free when you die (the benefit payment is reduced by the loan principal and accrued interest). There's no tax on loan proceeds and no requirement to repay the money, as long as you don't let the policy lapse.

What about family members? If you are ill and have only a year or so to live, it would be crazy to sell the policy for any amount (or to let a family member with power of attorney do so). Your insurer may offer accelerated death benefits, freeing up the death benefit while you're still alive.

If investors find your policy extremely attractive because your life expectancy is short, it's worth making maximum effort to salvage the policy.

"You might want to schedule a meeting with your beneficiaries and say, 'This is what I'm thinking about doing. Here's what it might cost to keep this policy in effect,'" says Adam Hamm, North Dakota's insurance commissioner.

Your sons and daughters or other heirs might pitch in to help pay the premiums or lend you the money because they'll end up with a much bigger and tax-free payout if you maintain the coverage. "If the offer is $200,000 today, before taxes, or $1 million tax-free if you keep the policy, what would you do if you were the beneficiary?" Hamm asks.

Smart shopping

If you decide that a life settlement is still your best option, you want to ensure you negotiate the fairest deal. You can get a ballpark estimate by using Illinois insurance adviser Hood's free tool at Policy Settlement, but that's just a start.

Continued: Shop around

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