If you or a loved one are considering a viatical settlement, you might be wondering how your payout will be taxed, and the common perception of all viatical settlements being tax exempt is unfortunately untrue. In this post, we will explain the current federal guidelines and laws in effect regarding the taxation of viatical settlements.
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 greater than the surrender value but smaller than the death benefit.
Unfortunately, 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 Internal Revenue Code. For this reason, it is important 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 similar to a death benefit. This means the money you recieve 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.
The first requirement is the policyholder must be a terminally ill individual with a life expectancy less than two years or have been diagnosed with a chronic condition. Company policyholders do not qualify for tax free viatical settlements. Second, 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 certain requirements agreed to in the Viatical Settlements Model Act.
This simply 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 certain 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.
While most viatical settlements are indeed free from federal taxes, it is important 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.
For those viatical settlements that do not meet these requirements, the payout will be treated as ordinary income and taxed accordingly. 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, please post them in the comments!
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.