Chapter 6: Life Settlement Taxation
How are life settlements taxed?
Generally speaking, gross income includes income from all sources, including gains from the sale of a life insurance contract. For tax purposes, the proceeds of a life settlement, fall into one of three categories:
- Sale proceeds up to the tax basis are free of income tax
- Sale proceeds in excess of the tax basis up to the amount of cash surrender value are taxed as ordinary income rates
- And sale proceeds in excess of the cash value are taxed at capital gains rates.
The basis of a life insurance policy is generally the premiums paid less withdrawals and dividends taken from the policy.
The 2017 Tax Cuts and Jobs Act signed into law by President Trump on December 22nd 2017 contains an important reform to the way life settlement transactions are taxed. Indeed, the new tax law overturns a 2009 ruling that required policy sellers to reduce their tax basis in a life insurance policy by deducting the cost of insurance charges over the elapsed term of the policy.
This was a significant hurdle, as it is particularly difficult for individuals to obtain the policy’s cost of insurance prior to a sale. With the ruling overturned, life settlements are now treated similarly to surrendered life insurance policies.
A real-life example
Bobby is a 79-year old retiree who decides to sell his $800,000 life insurance policy to pay down outstanding debts. At the time of settlement, Bobby had paid total premiums of $60,000 and the policy has a cash surrender value of $25,000. The policy sold for $100,000.
- Up to the policy basis there is no tax obligation. $100,000 (sale price) – $60,000 (policy basis) = $40,000 (taxable gain)
- Proceeds in excess of the tax basis up the the surrender value are ordinary gains. $25,000 (surrender value) – $100,000(sale price) = <0 (no ordinary gains)
- The remaining tabable proceeds are capital gains.$40,000 (taxable gain) – 0 (ordinary gains) = $40,000 (capital gains)
The taxation of proceeds from a life settlement should be considered when deciding whether or not to sell your policy. We recommend you consult with your accountant or tax advisor.
Are there exceptions?
Yes – for those suffering from chronic or terminal illness.
The Internal Revenue Code has a different treatment for life settlements where the insured qualifies for tax purposes as chronically or terminally ill. These transactions, known as viatical settlements, are considered more like accelerated access to the death benefits. Generally, life expectancies in these transactions are two years or less and the do not trigger tax obligations.