How the sale of your life insurance policy is taxed is an important question to answer before considering a life settlement. Selling a policy can provide access to funds for healthcare, living expenses, or other financial needs, but the money you receive may be subject to tax. The Tax Cuts and Jobs Act of 2017 (TCJA) clarified the rules, making it easier for policyholders to understand how their settlement will be treated. Since that update, there have been no further finalized changes to how policyowners are taxed when selling a life insurance policy.
Understanding the Basics
When the IRS looks at the proceeds from a life settlement, three numbers are important:
- Cost Basis: The total premiums you have paid into the policy, minus withdrawals, loans, or dividends.
- Cash Surrender Value: The amount your insurance company would pay if you surrendered the policy directly.
- Sale Price: The amount you receive when selling your policy in the secondary market.
These numbers are used to determine whether the money you receive is free from tax, treated as ordinary income, or taxed as capital gains.
How Proceeds Are Treated
- Tax-Free Amount
The part of the settlement equal to your cost basis is not taxable because it represents the return of money you already paid into the policy. - Ordinary Income
Any amount you receive above the cost basis and up to the surrender value is considered ordinary income. - Capital Gains
Any proceeds above the surrender value are taxed as long-term capital gains.
This framework replaced the older, more complicated method that required factoring in “cost of insurance” charges, which were difficult to track. The TCJA simplified the process by defining the cost basis as the total premiums you paid, adjusted for any amounts you have already taken out of the policy.
Example of Life Settlement Taxation
Consider a policyowner with a $500,000 life insurance policy. They have paid $75,000 in premiums over the years, which establishes their cost basis. The policy has a cash surrender value of $10,000, and they receive a life settlement of $145,000.
- Tax-Free Portion: $75,000 (equal to the cost basis)
- Ordinary Income: $0 (because the surrender value is less than the cost basis)
- Capital Gains: $70,000 (the amount above the cost basis)
If the surrender value had been higher than the cost basis, the amount between those two numbers would have been taxed as ordinary income. Anything above the surrender value would still fall under capital gains.
Life Settlements vs. Viatical Settlements
Not every sale is taxed the same way. The IRS makes a clear distinction between life settlements and viatical settlements.
- Viatical Settlements: If you have been diagnosed with a terminal illness and meet federal requirements, the proceeds are generally treated as an advance of the death benefit and are tax free.
- Life Settlements: If you do not qualify for a viatical settlement, the transaction is considered a sale and the proceeds are taxed according to the three-part structure described above.
Because tax treatment can vary depending on your policy, past withdrawals, and your overall financial situation, it is wise to review your circumstances with a tax advisor before making a decision.
Why Taxation Matters
Understanding taxation before selling a policy is important because it affects how much of the settlement you actually keep. A large increase in ordinary income may also influence eligibility for programs that use income limits. Knowing the basics helps make you better prepared when selling your policy.
Selling your life insurance policy can provide meaningful financial support, but taxation is an important part of the equation. Proceeds up to the cost basis are not taxed, amounts between cost basis and surrender value are ordinary income, and anything above surrender value is considered capital gains. If you qualify for a viatical settlement, the proceeds may be entirely tax free.
To learn if you qualify for a viatical or life settlement, please give us a call at 800-973-8258.
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