Life Settlement Taxation: How it Works

Last updated on May 6, 2019 by Chris Granwehr in Industry News, Life Settlements

Happy seniors filing their taxes after a life settlement.

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Are you thinking about a life settlement transaction? Many people are surprised to learn that they can sell their life insurance policy for more than the policy’s cash surrender value. Selling your life insurance policy is a great way to get cash that can improve quality of life later during retirement.

But before you pull the trigger and take advantage of this hidden asset, you need to understand the tax consequences of selling your life insurance. Because with any large financial transaction, you can be sure that Uncle Sam will be looking for a cut.

Fortunately,  the tax consequences of selling your life insurance have become simpler with the new Tax Cuts and Jobs Act of 2017 (TCJA).

This article will discuss how life settlements are taxed, how the TCJA affects life settlements, and what you can expect to pay in taxes if you complete a life settlement option.


How Are Life Settlements Taxed?

When you sell your policy, you will be taxed in three tiers:

  1. Proceeds received up to the tax basis (total premiums paid) are free of income tax.
  2. Proceeds received that are greater than the tax basis up to the amount of the cash surrender value are taxed at ordinary income rates.
  3. Proceeds received that are in excess of the amount from tier 2 get taxed as capital gains.

So what does all this mean?

Let’s look at an example:

  • Life Insurance Policy Cash Surrender Value: $95,000
  • Total Premiums Paid by Policy Holders (Tax Basis): $75,000
  • Amount Received in Life Settlement Transaction: $100,000

You can figure out the taxable amount by subtracting the cumulative premium payments from the life settlement proceeds:

Life Settlement Proceeds: $100,000

Paid Premiums (Tax Basis): $75,000

Taxable Income: $25,000

The amount of those gains that will be treated as ordinary income is the cash value of the policy minus the tax basis (the dollar amount of premiums paid on the policy):

Cash Surrender Value: $95,000

Paid Premiums (Tax Basis): $75,000

Amount taxed as ordinary income: $20,000

The remaining amount of the taxable income ($25,000-$20,000=$5,000) is the amount that will be taxed as long term capital gains.

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We should note, this example assumes that the policy owner is not terminally or chronically ill and has paid premiums on the policy for at least 8 years. This just a basic example, to understand how your life settlement would be taxed, contact your financial advisor or tax advisor for a thorough policy review.


What Does TCJA Have to do With Life Settlement Taxation?

Campaigns for the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act of 2017 makes figuring out your tax basis significantly easier. Previously, based on Revenue Ruling 2009-13, there was a different tax basis calculation for people selling their insurance policies and those surrendering.

For people surrendering their policies, the tax basis was their cumulative investment in the contract. This is generally the premiums paid less any withdrawals and dividends.

For people selling their policies, the IRS ruled that this basis needed to be further reduced by the cumulative cost of insurance. This meant that people selling their policies had to track down their cumulative cost of insurance – a number many insurance companies don’t even have on file.

More importantly, it meant that a smaller portion of the proceeds was tax-free. Thanks to the TCJA, this is no longer that case.

TCJA removes the need to factor in the cumulative cost of insurance and makes the basic calculation for both life insurance settlements and surrenders the same. Those selling their policies no longer need to reduce the taxable basis by the cumulative cost of insurance charges.

That might sound complicated, but the end result is lower capital gains tax.

Less work and more money. We love that here at Mason Finance.


What This Means For Policyholders

A woman and her grandchild benefiting from the new life settlement taxation laws.

When it comes to life settlement taxation, the Tax Cuts and Jobs Act reduces the amount of capital gains tax that life settlement recipients need to pay.

This is good news if you are considering your selling your life insurance policy.

Life Settlement Taxation (Summary)

Life settlement taxation works in three tiers. The amount paid into the policy (the tax basis) is tax-free. Proceeds greater than the tax basis, but less than the cash surrender value, are taxed at ordinary income rates. Any remaining amount is subject to capital gains tax.

Mason Finance does not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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Chris Granwehr
Chris Granwehr
Chris Granwehr is the SEO Lead at Mason Finance Inc. He graduated with a B.S. in business administration from Penn State University.

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