Life settlements are life insurance policies purchased in the secondary market from seniors who no longer want or need the policies. An investor purchases the policy for a lump sum cash payment, assumes the obligation to pay on-going premiums and collects the death benefit when the policy matures.
As an asset class, life settlements grew rapidly from the late 1990s through 2008. While the life settlement market experienced significant contraction during the financial crisis of the last three years, it is firmly established as a viable alternative asset class with little or no correlation to the capital markets.
The attractive characteristics of life settlements have led some with self-directed individual retirement accounts (“IRA”) to wonder if they can allocate IRA funds to the asset class; and, indeed, there are third parties in the market who offer to assist in such allocations. There is, however, a question as to whether it is permissible to invest IRA funds in this manner.
Section 408(a)(3) of the Internal Revenue Code provides that “no part of the trust funds [in an IRA] will be invested in life insurance contracts.” On its face, this section appears to prohibit the use of IRA funds to invest in life settlements. On the other hand, life settlements did not exist when § 408(a)(3) was added to the Code, and it is more likely that the provision was intended to address the purchase of life insurance on one’s own life, not the investment in a policy on an unrelated third party.
Several private letter rulings issued by the IRS have addressed whether IRA funds can be used, even indirectly, to purchase life insurance. The answer is definitively no. While it does not appear the IRS has directly addressed the issue of using IRA funds to invest in life settlements, there is a risk that IRA investments in an entity designed to invest in life settlements, or a direct investment by an IRA in life settlements, would violate § 408(a)(3) and result in disqualification of the IRA.
This potential risk is recognized in statements released by several state securities departments. In virtually identical releases, the securities departments of Arkansas, Kentucky and Oregon state “Internal Revenue Code Section 408(a)(3) requires that ‘no part of trust [IRA] funds will be invested in life insurance contracts.’ This means that the Internal Revenue Service may not allow you the tax benefits of an IRA if you invest in a life settlement contract.”[1]
If the IRS or the courts conclude that an IRA’s purchase and ownership of life settlements is substantially equivalent to the IRA’s purchase and ownership of a life insurance policy in violation of § 408(a)(3), the resulting income tax consequences may be materially adverse to both the IRA and its owner. Specifically, the IRA’s tax-deferred status could be terminated immediately and the entire balance of the IRA deemed immediately distributed to the IRA owner. This deemed distribution of the account balance may be fully taxable as ordinary income to the IRA owner and, if the IRA owner is not at least 59 ½ years of age at the time of such deemed distribution, may be subject to an early withdrawal penalty equal to ten percent (10%) of the entire account balance. As a result, any IRA owner interested in allocating any portion of their IRA assets into life settlements should consult a tax advisor, and possibly seek a ruling from the IRS as to its permissibility, prior to making any such investment.
[1] http://www.kfi.ky.gov/NR/rdonlyres/EAA9C45B-8F8F-4201-9102-E6AD9252541E/0/Form410AJuly2011versionLifeSettlementDisclosureA.doc;http://www.securities.arkansas.gov/!userfiles/Life%20Settlement%20Disclosure%20Document%20I.pdf;http://dfcs.oregon.gov/faqs/faq_pages/viatical.html