Life Settlement Taxation: Everything You Need to Know

The image shows a senior couple discussing their life settlement taxation.

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If you own a permanent life insurance policy that you no longer want or need, then you may want to consider selling your policy to a third party as a life settlement transaction. This type of sale can give you a substantial sum of money now and free you from the obligation of having to continue paying the premiums on your policy. Just be sure to take life settlement taxation into account before you sign on the dotted line. Read on to find out how these transactions work and what they can do for you.

What is a life settlement?

Life settlements are specialized transactions where an insured (who usually must be at least 65 years old) owns a cash value life insurance policy with a face value (death benefit) of at least $100,000.

For whatever reason, the insured no longer wants or needs the policy but needs cash now to pay for medical or other expenses. Therefore he or she can sell their life insurance policy, such as a whole life policy to a life settlement company in the secondary market. Here’s how it works:

  1. The life settlement company will analyze the insured’s life insurance contract and gather information on the insured’s health condition. Life settlement companies generally look for policies with high death benefits and lower premiums.
  2. Once the settlement company has finished processing all of this information, they will make an offer to the insured to buy the policy.
  3. If the insured agrees, he or she will sign over the ownership of the policy to the life settlement company.
  4. The company will assume the responsibility of making the insurance premium payments for the policy.
  5. The company will name itself as the new primary beneficiary on the policy and will collect the policy’s death benefit upon the death of the insured.

Life settlement companies like buying policies from insureds that are not likely to live out their actuarial life expectancy, because if the insured dies sooner, then the settlement provider will recoup its premium outlay and make a profit that much sooner. Therefore, insureds who meet these conditions will generally receive the highest payout offers for their policies.

Life settlements became mainstream transactions in the 1990s and have continued to pick up steam ever since. This market has now made itself known to the general public, and at the present time, it looks like it’s full-steam ahead for this industry as thousands of senior citizens want to sell their policies in return for cash upfront.

Life settlement taxation

If a life settlement does not qualify as a viatical settlement, then the sale proceeds that are received from the transaction will be taxed accordingly. The tax consequences of life settlements is fairly straightforward in most cases. The greater the amount of the policy, the more tax you will likely pay. The sale proceeds are simply divided up into three separate categories as follows:

  1. The total amount of premiums that were paid into the policy is treated as a tax-free return of principal.
  2. The amount of the cash value in the policy that exceeds the total amount of premiums paid is taxed as ordinary income. This means that it will be taxed at the insured’s top marginal tax rate.
  3. Any sale proceeds that exceed the amount of cash value in the policy is taxed as a long-term capital gain.

An example of life settlement taxation

Mary sold her $1 million whole life policy to a life settlement company for $250,000. She has paid $150,000 in total premiums over the past 25 years. The cash value in the policy now stands at $200,000. How will she be taxed on this transaction?

  1. The $150,000 she paid for premiums will be considered a tax-free return of principal.
  2. The $50,000 difference between the amount of premiums that she paid and the current cash value will be taxed as ordinary income. This means that she will pay tax on this amount at her top marginal tax rate.
  3. The $50,000 difference between the amount of cash value in the policy and the sale price will be taxed as a long-term capital gain.

The tax rules for life settlements stand in stark contrast to the tax rules for their viatical cousins. Viatical settlements are usually tax-free because they are considered an advance payment of the death benefit (which is also always tax-free), provided that both the buyer and the insured meet certain requirements.

But while viatical settlements can only be done with either terminally or chronically ill patients, life settlements are generally available to anyone who is at least 65 years old and has any type of cash value policy with a death benefit of at least $100,000.

A happy senior couple hugging in the park, celebrating their life settlement payout.

Don’t forget to account for state income taxes when you sell your policy. Some states will treat your profit on the sale as taxable income, while others treat this type of transaction with capital gains tax treatment.

On the other hand, some states don’t levy income taxes of any kind at all. So talk to your tax advisor and find out what the state tax ramifications will be on your sale so that you can be prepared.

Can I sell my life insurance policy?

If you own any type of cash value life insurance policy, such as a whole life policy, universal life policy, or variable universal life policy, then you can sell it as long as the life settlement company considers the death benefit for your policy to be large enough to warrant buying. If you own a convertible term life insurance policy, then you can convert it to a smaller amount of paid-up permanent coverage and then sell that, provided that the death benefit is still large enough.

Consult your financial adviser

If the life settlement provider comes back with an offer to buy your policy and you are satisfied with the price, then the settlement company will promptly pay you your settlement proceeds. But it would be wise for you to consult your financial advisor and also a qualified tax advisor about the particulars of doing this type of transaction.

There may be nuances in the tax laws of the state you live in that you will need to know in order to do the sale correctly, and you also need to do some research on your potential buyer in order to ensure that they are properly licensed in the state you live in (assuming the state has a licensure requirement).

Solicit multiple offers

Don’t hesitate to shop around to see who will give you the best deal. You may be surprised at the dollar difference between the highest and lowest bidders.

You should do this even if you are in a rush to get the sale proceeds, because you may end up with substantially more from one settlement company than you will get from all of the rest of them. Life settlement brokers can also help with the process, though they will charge a percentage of the death benefit.

Also, if your policy has accelerated death benefits, then be sure to compare them to the amount that the life settlement company is offering you. If the accelerated benefits are larger than the sale proceeds, then you’ll need to think carefully about whether selling makes sense for you or not.

If your policy has a rider for long-term care expenses, then it may be wise to keep your coverage if you think that there’s a good chance that you will need this form of care in the future.

Life settlements vs. viatical settlements

Viatical settlements were born in the wake of the AIDS epidemic of the 1980s. At that time, there were many young, terminally ill policyholders who needed money immediately to pay for medical bills.

Viatical settlement providers, called viators, appeared and made policy owners a viatical settlement offer in return for their life insurance policies. The settlement company would name itself as the new owner and beneficiary and then assume the responsibility for paying the policy premiums until the death of the insured.

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Then, just as with a life settlement, the viatical settlement company would collect the death benefit, recoup its premium outlay, and also make a profit. In many cases, a viatical settlement broker would act as a go-between for the settlement company and the insured.

In general, viatical settlements are tax-free transactions, because the immediate cash payment is considered to be an advance payment of the death benefit (which is also always tax-free). However, viatical settlements come with several requirements that both the buyer and the seller have to meet in order to avoid taxation. They include:

  1. The buyer must be a qualified buyer in the eyes of the Internal Revenue Service and other government agencies. This means that they must be licensed in the state that they are doing business in (assuming the state has licensure requirements), and they must be following all of the laws and rules governing viatical settlements set forth by both Congress (such as the Health Insurance Portability and Accountability Act (HIPAA)), the department of insurance and the self-regulatory agencies in the viatical industry such as the National Association of Insurance Commissioners (NAIC). They must also adhere to the tenets of the Viatical Settlements Model Act. Furthermore, the buyer must purchase policies on an ongoing basis as the main source of its revenue.
  2. The insured must be terminally ill with a doctor’s signed affidavit dictating that the insured has two years to live at most, and probably less than that.
  3. Chronically ill insureds must be classified by a doctor as being permanently unable to perform at least two out of the six activities of daily living (ADLs), which include eating, walking, bathing, toileting, transferring (as from a wheelchair to a bed) and grooming. The life settlement proceeds of chronically ill insureds are tax-free to the extent that the sale proceeds are used to pay for qualified medical expenses. These expenses cannot be covered by any other type of insurance, such as private health insurance, long-term care insurance, Medicare, or Medicaid.

These are just a few of the criteria that buyers and sellers have to meet in order for the viatical settlement proceeds to qualify for tax-free status. Previously, the IRS was silent on how these sales should be taxed, which opened the door for widespread tax evasion and a great deal of confusion for income tax preparers.

Fortunately, the tax rules for viatical settlement are much clearer now. But anyone who wants to pursue this type of sale would be wise to consult with a qualified financial planner or tax advisor before doing so, so that they can find out about any special tax laws that may apply in their state. Some states have guidelines that differ from those set forth by the IRS, so it is important for potential sellers to do their homework on this before moving forward.

The new Tax Cuts and Jobs Act of 2017 (TCJA)

The history of life settlement taxation only goes back to the 1990s, but legislatively speaking, it has evolved fairly quickly since then. The first piece of legislation that appeared in May of 2009 was the IRS revenue ruling 2009-13. This ruling immediately went into effect and it contained two separate sets of rules for the life settlement industry.

One set of rules pertained to all life settlement transactions that were conducted before August 26th, 2009. The other set pertained to all life settlements that were conducted after that date. The former set of rules dictated that the amount of the cost basis in a policy that was sold was classified as a tax-free return of principal.

If the policy’s cash surrender value in the policy exceeded the cost basis, then that amount was taxed as ordinary income, and any excess amount of sales proceeds that exceeded the cash value was taxed as long-term capital gains.

The latter set of rules was very confusing. The rules for life settlement transactions done after August 26th, 2009 were broken down into three separate sets of guidelines, broken down as follows:

  1.  Surrender of a life insurance policy back to the insurer – If a policyholder decided to surrender his or her life insurance policy back to the insurance company, the insured would be taxed on the amount of cash value that exceeded the total amount of premiums paid. This difference would be taxed as ordinary income.
  2. Sale of term life insurance – In this case, the cost basis of the policy equals the total premiums paid minus charges for the cost of insurance. If the insured doesn’t have documentation specifying the cost of insurance, then the cost of insurance is assumed to be the same as the policy’s premium. The difference between the sale proceeds and the cost of insurance is taxed entirely as a long-term capital gain.
  3. Sale of a permanent life insurance policy – As with a policy surrender, the difference between the total premiums paid minus the cost of insurance and the current cash value in the policy was taxed as ordinary income. Sale proceeds that exceeded the current cash value was taxed as a long-term capital gain.

Needless to say, this onerous set of rules created several problems for both policyholders and tax professionals. There was a distinct discrepancy between the tax treatment of permanent life insurance settlements and surrendering a policy. The life settlement tax rules required the insured to lower his or her cost basis by the cost of insurance.

Unfortunately, the cost of insurance was often impossible to obtain from life insurance companies. But policy surrenders did not have this requirement. Life insurance sellers were then required to simply assume that the total amount of premiums paid equaled the cost of insurance, which was inaccurate.

Fortunately, the Tax Cuts and Jobs Act of 2017 resolved this dilemma by dictating that the total cost of premiums paid was always the cost basis of the policy. This effectively lowered the amount of tax that the insured would owe and also streamlined the sale process.

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The taxation of life settlements has been considerably simplified by the Tax Cuts and Jobs Act of 2017. Nevertheless, it would be wise to consult with your tax or financial advisor to find out if there are any specific nuances in your sale that might complicate things.

Each state has its own set of tax laws governing the taxation of these transactions, so be sure to find out your state’s rules so that you don’t get a nasty surprise when you file next year. The tax rules for Florida won’t necessarily match up with the tax rules in other states, such as New York, Wyoming or Rhode Island. Also be sure to discuss this matter thoroughly with your family members and loved ones so that they will know not to expect to receive any death benefit.

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Author:
Chris Granwehr is the Founder of Dawn Life Settlements and a former senior manager with Mason Finance, an industry-leading life settlement provider in California. He's a member of the Life Insurance Settlement Association, and he has a passion for empowering customers financially through a faster, easier life settlement system.