For years, the tax laws governing the sale of a life insurance policy were very onerous. But in recent years, the IRS has laid out a boilerplate set of rules that all sellers can use to determine how much they owe on their sales.
The taxation of a life settlement will depend upon how much cash value was in the policy, the sale price and the amount of premiums that were paid into the policy since its inception. In most cases, the sales proceeds are divided up into three categories and taxed differently in each category. This is broken down as follows:
- The portion of the sale price that equals the amount of life insurance premiums already paid into the policy is classified as a tax-free return of capital for the purpose of tax basis.
- The portion of the sale price that exceeds the amount of premium paid up to the amount of cash value in the policy is taxed as ordinary income (which means that you’ll pay tax on this amount at your top marginal tax rate).
- Any amount that exceeds the cash value in the policy is taxed as a long-term capital gain.
Bill paid $40,000 of premiums into his indexed universal life policy. He has $55,000 of cash value in the policy and sells his policy for $65,000. The first $40,000 of the sale is considered a tax-free return of principal. The next $15,000 is taxed as ordinary income. The final $10,000 is taxed as a long-term capital gain.
Although these rules generally apply to all settlement transactions, there are also state-specific rules and regulations that can apply in certain situations. Be sure to consult with a qualified tax advisor on this matter before you file your tax return.