Mastering the Art of Life Insurance Settlements and Taxation in 2024
Here's a guide to how selling policies affects clients' taxes.
The tax notices are flowing in.
Seniors, life insurance agents, financial advisors and accounting professionals are thinking about tax preparation. Questions often arise about the taxation of life insurance settlements.
It’s essential to seek guidance from a tax professional, but understanding the basics can provide a solid foundation for helping clients make informed decisions.
Viatical and Life Settlements Basics
There are two main categories of life insurance policy sales: viatical settlements and life settlements.
Viatical settlements: This term applies to transactions involving seniors or others with a terminal illness that’s expected to result in death within 24 months.
For clients who make viatical settlement deals, the proceeds are typically tax-free.
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.”
Traditional life settlements that are taxed in tiers:
First tier (tax-free): Proceeds from the settlement that equal your client’s tax basis are not subject to tax.
The tax basis typically includes the total premiums paid on the policy.
For instance, if the settlement amount is $100,000 and your client’s tax basis (the total premiums paid) is $50,000, there is no tax on this initial $50,000.
Second tier (ordinary income tax): Proceeds that exceed your client’s tax basis but are less than or equal to the policy’s cash surrender value are taxed as ordinary income.
Continuing the example, if the policy’s cash surrender value is $80,000, and your client’s basis is $50,000, the next $30,000 of the settlement proceeds will be taxed as ordinary income.
Third tier (capital gains tax): Any proceeds that surpass the cash surrender value of the policy are subject to capital gains tax.
In the given example, if the settlement is $100,000 with a cash surrender value of $80,000, the remaining $20,000 is taxed as capital gains.
This structure is a simplified representation but provides a basic guideline:
- Proceeds up to your tax basis (the total premiums paid) are not taxable.
- Proceeds exceeding the tax basis but within the cash surrender value are taxed as ordinary income.
- Proceeds above the cash surrender value are subject to capital gains tax.
State-Level Taxation
The taxation of capital gains may differ based on state laws.
States like Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming have no ordinary income or capital gains tax and therefore offer a significant advantage.
There is some preferential tax treatment for capital gains from nine other states, including Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont, and Wisconsin.
States not listed above will likely tax the proceeds of a life settlement more heavily, so it’s best for clients to seek professional tax advice in their own states.
Estate Tax Considerations
Many seniors acquired life insurance policies to prepare for estate taxes.
However, with the significant increase in federal estate tax thresholds in 2024 ($13.61 million for individuals, $27.22 million for couples), the relevance of these policies may have diminished for many.
This shift makes life settlements an attractive option for those whose estates fall below these thresholds.
When Clients Should Consider a Life Insurance Settlement
If your client’s original intention was to let a policy lapse, a life settlement could provide financial gains that would otherwise be forfeited.
It’s crucial to conduct a policy appraisal to understand the policy’s potential value on the secondary market.
Situations that often warrant a client considering life insurance settlement include:
- Policies are purchased to protect a spouse who has passed or if there has been a divorce.
- Policies purchased for a business reason that is no longer relevant.
- Policies where the beneficiary has passed away, or the policy is no longer wanted.
- Policies with burdensomely escalating premiums.
Whether addressing estate tax changes or evaluating when a policy appraisal is necessary, staying informed and seeking expert advice, including advice from a tax professional, is key to making the most of life insurance settlements.
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