A viatical settlement gives terminally ill individuals cash in exchange for their life insurance policies. A viatical settlement company pays the insured a portion of the face value of his policy in exchange for all rights to the policy upon the insured’s death. In most cases, life insurance payments to the terminally ill are not taxable.
Accelerated Death Benefits
The IRS refers to the money that changes hands in a life insurance settlement transaction as accelerated death benefits. According to the IRS’s Tax Guide for Seniors, viatical settlement taxes are not owed under certain circumstances.
Certain amounts paid as accelerated death benefits under a life insurance contract or viatical settlement before the insured’s death are generally excluded from income if the insured is terminally or chronically ill.
IRS Publication 554 (2012)
Note that the exclusion from income cannot be claimed by a beneficiary who receives a settlement for an insurable interest that arose because the beneficiary was the insured’s employer or an investor in the insured’s company.
Viatical Settlement Taxes: Qualified Individuals
To exclude a life insurance settlement from your income and reduce your viatical settlement taxes to zero, you must have a terminal or chronic illness. You may qualify if you meet these criteria:
- A physician has certified you as having an illness or condition that can reasonably expected to result in your death sometime during the 24 months following the certification; or
- You are not terminally ill, but within the past 12 months, a physician has certified you as having a chronic illness.
If your life expectancy is longer than 24 months, your benefits will be taxed based on the amount of premiums you have already paid. Taxation of a life settlement is complex and depends on your life expectancy, how much you have paid in insurance premiums and how much you receive for your settlement. Your settlement may be treated as ordinary income or a capital gain for tax purposes. It’s a good idea to get tax advice from a professional before you commit to a settlement.
One way to meet the “chronic illness” requirement is for you to have a loss of functional capacity that makes you unable to perform two or more of the following activities for 90 days or more without substantial help:
- Using the toilet
- Moving from a bed to a wheelchair or from wheelchair to car
- Taking a bath or shower
- Getting dressed or undressed
- Controlling your bowels or bladder
If the insured has severe cognitive impairment, he meets the chronic illness requirement if he needs “substantial supervision” to protect his health and safety because of his mental impairment.
For the chronically ill, life insurance settlement money may be excluded in its entirety from taxable income if it is used to pay for long-term medical care for the insured. Settlement money not spent on medical services is excludable up to a limit.