Even when a client purchases a “permanent” type of life insurance policy (such as a whole life policy), situations can arise in which the investment may simply no longer make sense.
If this is the case, the client may consider either selling or surrendering the policy in order to free up those assets for allocation toward more advantageous investment products. However unnecessary a life insurance policy investment may have become, the client must be sure to carefully evaluate the detailed tax consequences that the IRS has outlined in a variety of rulings in order to gain a comprehensive picture and ensure that a sale or surrender is a wise choice.
Tax Consequences Upon Sale or Surrender
While life insurance policy loans and death proceeds are generally received income-tax free, the same favorable tax treatment does not necessarily apply upon sale or surrender of a policy.
Gain on a life insurance policy is measured as the difference between the client’s basis in the policy (usually the amount of premiums that he or she has paid) and the policy’s cash value. The cost of insurance is also subtracted from the amount of premiums the client has paid to arrive at the basis figure.
Generally, when a life insurance policy is sold to an investor (a transaction often referred to as a “life settlement”), the policy owner will be required to recognize ordinary income to the extent of his or her “gain” on the contract. If the client receives amounts in excess of the cash value upon the sale, that excess amount is taxed as capital gain.
One problem that clients will often encounter is how to determine the cost of life insurance protection that must be subtracted in order to determine the contract’s basis. While the IRS does not offer definitive guidance, this figure can usually be obtained from the insurance company issuing the policy.
If the policy is surrendered, the client’s tax liability must be calculated by first determining his or her investment in the policy under IRC Section 72. Investment in the policy is generally the amounts paid for the insurance minus any amounts that had already been received under the insurance policy (loans, for example) that were excluded from gross income. The excess of what is received over the investment in the contract is taxed as ordinary income.
The Typical Candidate and Other Non-Tax Considerations
Clients may decide that a life insurance policy investment is no longer advantageous or necessary for a variety of reasons. Frequently, the client may simply find that the policy itself is no longer the best option or that the individuals that the policy was purchased to protect no longer strictly need the same degree of financial protection (i.e., because children have grown into responsible adults).
However, clients who choose to sell or surrender a policy because it has become difficult to pay the policy premiums should first evaluate whether it would be difficult to obtain a similar life insurance policy (perhaps because of health reasons) as a replacement in the future. Further, the funds obtained from sale of a policy can make it more difficult for clients to qualify for Medicaid (if, for example, they require care in a nursing home).
Clients should also remember that they may be able to borrow from whole life insurance policies on a tax-free basis if the policy has accumulated substantially. This can provide an alternative route for clients looking to sell a policy because they need the extra funds, but still anticipate that the policy can provide value through its death benefit in the future.
While there are a variety of reasons why a client may choose to sell or surrender a life insurance policy, the sometimes-complicated tax consequences must be taken into account as part of the equation in determining whether such a sale is really the wisest choice.
-- For previous coverage of life settlements in Advisor’s Journal, see http://nationalunderwriteradvancedmarkets.com/articles/default.aspx?filename=fc080112-d.htm&search=life%20settlement&type=and
-- For in-depth analysis of the tax treatment of life insurance, see Advisor’s Main Library: http://nationalunderwriteradvancedmarkets.com/articles/default.aspx?filename=f105-7_1_105_1470.htm&search=life%20insurance%20sale&type=and