We have been noticing an increase in the number of advisors suggesting that investors place a portion of their self-directed IRA investments in life settlements. These are life insurance policies purchased from the original policy owner who, for whatever reason, no longer needs or wants a life insurance policy. When this happens, the policy owner may surrender the policy back to the insurance company for the cash surrender value. In some cases, though, a third party may be willing to pay more for the right to the eventual death benefit than the insurance company is willing to pay. This is especially true if the insured is in poor health and expected to pass away before his or her normal actuarial life expectancy passes. The third party buys the policy, pays any premiums that come due, and collects the death benefit when the insured dies.

Advantages

Over time, investors have found that a portfolio of life settlements is a good way to generate solid investment returns with only modest risk – chiefly that the insured individuals don’t die on schedule as expected. Furthermore, life settlements have proven to have no correlation with other asset classes, like stocks or bonds.

Disadvantages

In the context of self-directed IRAs, however, there is one issue that makes using life settlements in IRAs extremely problematic: It’s against the law.

Specifically, Section 408(a)(3) of the Internal Revenue Code specifies that “no part of trust [IRA] funds will be invested in life insurance contracts.” If you do, and the IRS finds out, they may disallow the entire account. When this happens, you may have to pay income taxes on the entire account value, plus penalties – the IRS will potentially deem you to have taken a distribution of all the assets in the account.

In short, there is simply not enough case law on this particular point to establish the legality of the practice. You could have an arguable case, sure – and even a plausible case. But unless the amounts involved are trivial, and you can easily afford to lose, the risks of not getting the verdict you hoped for are simply not worth the risk of attempting to own life settlements within a self-directed IRA.

Other considerations

Even if you could be certain that IRS and courts would allow you to hold a life settlement contract in a self-directed IRA, you should also carefully consider liquidity risk: There is no guarantee that the insured will die on schedule, before you turn 70½. This could cause you to have difficulty taking required minimum distributions – resulting in severe penalties equal to half the RMD amount you were supposed to take. You may be able to borrow money to bridge the gap – but it is impossible to predict the availability of credit years from now. You may not be able to get a loan against the policy to pay RMDs. You could try to sell the policy – but these are relatively illiquid investments, and you may not be able to find a buyer in time.

Simply put, there are too many pitfalls with holding life settlements within an IRA at this point for us to recommend the practice. If you encounter someone who is recommending you hold life settlements within your self-directed IRA, be very careful.

American IRA does not provide specific tax or legal advice. For advice pertaining to your specific situation, it’s important to retain the services of a qualified professional.

Alternatives

Fortunately, there are a lot of alternatives to life settlement investing that don’t present the same legal and practical difficulties. Our clients enjoy the freedom of choice to invest in a variety of assets with their self-directed IRAs including, real estate, private companies, limited liability companies, private placements, private loans, tax liens, gold or other precious metals, and so much more!

For more information, or to open an account with American IRA, call us today at 866-7500-IRA (472). We look forward to hearing from you.