How Taxation of Life Settlement Proceeds Works Now
The size of the tax bill depends partly on the health status of the client.
Tax season has come again.
One question that frequently arises about the secondary market for life insurance is: How are the proceeds of a life settlement taxed?
The answer: Well, it isn’t straightforward.
However, it’s a critical question as the amount of tax owed on a payment could significantly impact the assessment of whether or not an individual should sell a policy.
First and foremost, we always recommend that anyone who sells a life insurance policy into the secondary market should seek the advice of an accountant or tax expert.
Given that, here is some essential background regarding taxation to help serve as unofficial guidance.
Taxes on ‘Found Money’
Before getting into the specifics of taxation, it’s important to note that if an insured sells a policy that would otherwise lapse, the tax consequences are less meaningful.
The funds from the settlement, essentially “found money,” wouldn’t exist without the settlement.
Even if the payment were heavily taxed, it would still be a better deal than letting a policy lapse and receiving nothing in return.
We would all rather pay taxes on found money than receive nothing.
The Health Status of the Insured
One of the first questions that should be addressed about taxation of life settlement proceeds is the health status of the insured who’s selling the policy.
If the insured is terminally ill, which means they have a life expectancy of fewer than two years, the settlement proceeds will be tax-free.
Technically, the transaction will be called a viatical settlement if the insured is terminally ill, and this has a different tax treatment from a life settlement transaction.
The IRS defines a terminally ill person as “someone who has been certified by a physician as having an illness or physical condition that can reasonably be expected to result in death in 24 months or less after the certification date.”
In addition, if the insured is chronically ill, the settlement proceeds may not be taxed.
The IRS defines a chronically ill individual as “someone who has been certified (at least annually) by a licensed health care practitioner as being unable to perform, without substantial assistance from another individual, at least two daily living activities (eating, toileting, transferring, bathing, dressing, and continence) for at least 90 days due to a loss of functional capacity.”
Or a person “requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment.”
The settlement proceeds will not be taxed if the insured is terminally ill or chronically ill by IRS standards.
Traditional Life Settlements
Taxation of a traditional life settlement is more complex.
Essentially there are three tiers of taxation.
The first tier is tax-free. Any proceeds obtained from the settlement, up to your tax basis, are not taxable. This would include premiums paid into the life insurance policy.
For example, if your settlement is $100,000, and your basis is $50,000, you would pay no tax on the first $50,000. However, you would pay taxes on the additional $50,000.
The second tier is taxed as ordinary income. Proceeds above your tax basis and up to the cash surrender value are taxed as regular income.
Anything above this is the third tier, taxed as a capital gain.
Using the example again of a $100,000 cash settlement, if your basis was $50,000, then $50,000 is tax-free.
If the cash surrender value is $80,000, you will pay ordinary income tax and capital gains on the next $30,000 and capital gains tax on the final $20,000.
Granted, this is a simplified example, but it represents general guidance.
- Sale proceeds up to the amount of the cost basis are not taxable.
- Sale proceeds above the cost basis and up to the policy’s cash surrender value are taxed as ordinary income.
- Any remaining sales proceeds are taxed as long-term capital gains.
Estate Taxes
The other area that’s important to understand is estate taxes.
Many life insurance policies were purchased to help cover estate taxes.
However, recent changes to the tax code have raised the estate tax exemption, which is currently $12.92 million for individuals and $25.84 million for married couples.
The vast majority of people will have estates less than this amount, but many folks purchased policies before the exemption was increased.
For anyone who purchased a policy more than five years ago with the intent to pay future estate taxes, the policy may no longer be needed due to the increased exemption — and, therefore, could be sold on the secondary market.
When to Get an Appraisal
Agents and advisors can help clients identify situations when a life insurance settlement makes sense, and it all starts with a policy appraisal.
Policies fitting in these categories are good candidates for an immediate appraisal:
#Purchased to fund a buy/sell agreement for a business that no longer exits
Key person policies on executives who have left a company nullify the need for the coverage
Policies where the beneficiary, such as the spouse, has passed away or the policy is no longer wanted
- A policy with escalating premiums that are economically burdensome
- When in doubt, we believe that agents and advisors should get policies appraised because understanding the potential value of a settlement is critical.
- And with an appraisal, it will be easier to determine the overall impact of taxes on a life insurance settlement.
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(Image: Andrii Vodolazhskyi/Shutterstock)