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If you or a loved one are considering a viatical settlement, you might be wondering if you have to pay taxes on your payout.
Most people seem to think that all viatical settlement proceeds are tax exempt.
Unfortunately, this is not always true.
In some instances, viatical settlement payouts are subject to state and federal taxes.
In this post, we will explain the current federal guidelines and laws in effect regarding the tax treatment of viatical settlements.
What is a Viatical Settlement?
As a reminder, a viatical settlement occurs when a terminally or chronically ill policyholder sells their life insurance policy to a third party. The price agreed upon is typically higher than the cash surrender value but smaller than the death benefit.
Viatical Taxation Federal Overview
Viatical settlement taxation is a complicated issue.
Tax codes on the federal level do not always coincide with those for different states, and states do not always follow the guidelines set by the IRS regarding viaticals. For this reason, it is essential to check with a personal tax or financial advisor and your state government for accurate and up-to-date policies for the taxation of viatical settlements.
At the federal level, most viatical settlement payouts are treated similarly to a death benefit. This means the money you receive is tax-free. But first, you must ensure you meet all of the requirements in the Internal Revenue Code, the piece of legislation that lays the foundation for viatical settlement taxation.
Instead of figuring out how the tax law will affect your life insurance settlement on your own, we recommend you consult with a financial professional.
Tax-Free Viatical Settlement Requirements
The first requirement is the policyholder must be terminally ill with a life expectancy of less than two years or diagnosed with a chronic condition.
Company policyholders do not qualify for tax-free viatical settlements.
Next, the policyholder must sell the life insurance policy to a licensed life settlement provider in their state. If your state does not require providers to be licensed, you can ignore this clause.
The provider must also be a regular purchaser of life insurance policies and abide by specific requirements agreed to in the Viatical Settlements Model Act.
This means that providers are required to pay a certain amount of the policy’s death benefit based on the policyholder’s life expectancy and meet specific operating standards. The shorter the life expectancy, the more money the provider must offer for the policy.
It is possible for chronically ill patients with life expectancies over two years to receive tax-free viatical settlements. In this situation, the policyholder must be unable to perform at least two activities of daily living (ADL) and must use the money from the settlement to pay for long-term care expenses that are not covered by their health or long-term care insurance.
Tax-Free Viatical Settlement Requirements (Summary)
- The policyholder must be terminally ill with a life expectancy less than two years OR diagnosed with a chronic condition.
- If the policyholder’s life expectancy is over two years, they must be unable to perform 2 activities of daily living.
- The policy must be sold to a state-licensed life settlement provider.
- The provider must abide by requirements agreed to in the Viatical Settlements Model Act.
While most viatical settlements are indeed free from federal taxes, it is essential to make sure you qualify. Choose a licensed provider in your state and inquire if they follow all of the requirements set out by the Viatical Settlements Model Act. To find a list of licensed viatical settlement providers, check your state’s Department of Insurance website.
Viatical Settlement Myths and Misconceptions
As the life settlement industry grows and viatical settlements become more popular, the internet has become flooded with information (and misinformation) about life settlements. Unfortunately, separating fact from fiction is not always easy.
The amount of conflicting information can make it a little scary for policyholders looking to enter the marketplace.
To help clear up any viatical settlement misconceptions, and to address any myths, here are some of the most common concerns we see when it comes to viatical settlements.
Myth #1: Viatical Settlements are a Scam
The thought that all viatical settlements are scams is perhaps the most frustrating misconception because it means that some people may have been taken advantage of.
The truth is that viatical settlements are a legitimate way to cash in on a life insurance contract for individuals with low life expectancies.
If you’re concerned about the legitimacy of a viatical settlement offer, it is best to work with a trusted life settlement broker or company. Also, don’t be afraid to shop around to get multiple opinions on your settlement.
Myth #2: Viatical Settlements are Always Tax-Free
As discussed above, viatical settlements must meet specific requirements in order to be tax-free. The first question you should ask when working with a life settlement company is if they are licensed by the state in which you reside. If they’re not, you could be opening yourself up to undesirable tax implications.
Myth #3: Viatical Settlements are for the Rich
For some reason, many people think that viatical settlements are only for wealthy individuals with expensive financial advisors.
This couldn’t be farther from the truth.
In fact, many policyholders choose viatical settlements because they need cash to pay for long-term care or they can no longer afford their insurance premium payments. If you can no longer afford the cost of insurance, or if your health insurance won’t cover your needs, use our life settlement transaction calculator to see how much you could get for your whole life or term life insurance policy.
While it is true that some wealthy individuals use viatical settlement proceeds for charitable giving or estate planning reasons, viaticals settlements are not limited to the rich.
Myth #4: Viatical Settlements are Risk-Free
While we are firm believers that viatical settlements and life settlements are sound financial tools, they aren’t right for everyone.
For instance, if your beneficiaries are reliant on receiving your death benefit after your passing, you could be putting your family members at risk.
Investing in viatical settlements is a different story. Some life and viatical settlement companies accept private investor money and use it to purchase policies from policy owners. Money invested with these companies is not insured by a government agency, so investments should be treated with caution. Mason Finance is not in the business of helping policy investors; we want to help policyholders, so we cannot provide advice on investing in life settlements.
To limit risks when selling your life insurance policy in a viatical settlement, make sure you understand the consequences and alternatives before signing any paperwork. One of the most common alternatives is to tap into your policy’s accelerated death benefit.
What if my Settlement is Taxed?
If your viatical settlement does not meet the tax-free requirements outlined above, portions of the payout will be subject to regular income tax. If your policy has a savings component, money accrued through investments will most likely be treated as capital gains (as opposed to ordinary income).
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Again, this process is different in every state, and states do not always follow the federal guidelines. Be sure to research your particular state’s laws and discuss with your tax or financial advisor.
If you have any further questions, feel free to contact us to learn more about viatical settlements.
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.