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Gather ‘round. This is must reading. If what you are about to read can’t help you save taxes or help you increase your personal tax wealth, it will certainly help someone you know.

Chances are you never even heard of the subject matter that we are about to discuss: life settlements (LS). An LS is a transaction involving an existing life insurance policy that is sold by its owner (usually the same person whose life is insured). Surprisingly, both the buyer and seller come out after-tax winners.

Here’s an example, from the seller’s (a client, Joe, of our office) side of the story. Joe, age 68, owned a life insurance policy on his life with a death benefit of $700,000 and a cash surrender value of $72,000 which was subject to a loan of $20,000. So Joe had equity of only $52,000.

An analysis of Joe’s insurance situation clearly showed that he and Mary (Joe’s wife) could buy $1.2 million of second-to-die life insurance for the same annual premium cost as Joe’s old policy. Done! Joe and Mary created an irrevocable life insurance trust to own the new $1.2 million policy. The $1.2 million will ultimately go to their kids… tax-free.

The old policy was sold to an investment group in an LS for $175,000 in cash. It should be noted that Joe’s obligation to repay the $20,000 loan was assumed by the investment group, so in effect, Joe got $195,000 ($175,000 + $20,000) for selling his policy. Over the years Joe paid a total of $174,000 in premiums, so the first $174,000 (of the $195,000) is tax-free. The balance — $21,000 – is Joe’s profit on the sale of this policy and enjoys capital gains tax treatment at only 15 percent. A real economic and tax winner for Joe and Mary.

Now let’s look at the other side — from the investor’s viewpoint — of the LS story. A number of entrepreneurs have formed companies that seek out people who want to sell their policies in a LS. These same companies seek out investors to buy the policies being sold. Typically, according to the investment groups, the investors earn from 14 percent to 22 percent per year, sometimes higher.

LS get a terrific tax break. Not one cent in tax is due until you receive back your investment and profit in cash. When the income from the LS is received, it is taxed as ordinary income. Of course, the income would be tax-deferred if received by a qualified plan (for example a 401(k) plan, a profit-sharing plan, or an IRA) that invests some of its funds in LS. Because of the potential high rate of return, you should consider a LS if you have funds in an IRA or any other type of qualified plan.

LS have become the darling of conservative investors who want a large rate of return without stock market risk. The big guys — like Warren Buffet’s Berkshire Hathaway and AIG, the insurance giant, have been investing in LS for years. Now, the little guy can join the profit making fun. Minimum investment is $50,000 for qualified investors.

For example, say you invest $100,000 with a group of other investors and the annual rate of return you finally earn is 15 percent per year over a four-year period (the seller of the policy went to heaven four years after you purchased the policy). So, your profit would be $60,000 (4 X 15 percent = 60 percent X $100,000 or $60,000). You would not owe any tax until you actually received your entire $160,000. If you invested your IRA funds, no tax would be due when the IRA receives the $160,000… tax is deferred until distributed to you.

If you would like to learn more about LS — either as a buyer or seller — fax Irv Blackman at 847-674-5299. Please put “LS” at the top of the page.

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Irv Blackman is a certified public accountant and lawyer who specializes in estate planning, business succession and asset protection. Contact him at Blackman@EstateTaxSecrets.com or call 417-9732. His Web site is www.taxsecretsofthewealthy.com.