Life Settlement Taxation: A Guide to Taxation Policies and Options

Life settlements can be a complex and often misunderstood financial product. In the United States, life settlements are considered taxable income, and the tax implications can be significant.

The IRS views life settlements as the sale of an asset, similar to selling a stock or real estate. This means that the seller is required to report the sale as ordinary income on their tax return.

The tax implications of a life settlement can be substantial, with tax rates ranging from 10% to 37% depending on the seller's income tax bracket.

Tax Implications can be complex, but let's break it down. If a term life insurance policy is sold, 100% of the life settlement proceeds should be treated as a capital gain, according to the IRS Guidelines.

The IRS considers the settlement amount minus the premiums paid into the policy as the overall tax liability. For example, if a term policy with a death benefit of $500,000 is sold for $70,000, and premiums paid into the policy were $15,000, the overall tax liability would be $55,000 ($70,000 - $15,000).

The tax liability is then used to determine the total tax owed, which in this case would be taxed at the policy owner's long-term capital gain tax rate.

A long-term capital loss policy can be a complex and nuanced topic, but let's break it down. A long-term capital loss occurs when the sale of a life insurance policy results in a loss, which is calculated by subtracting the settlement amount from the cost basis.

For example, if an individual sells a policy for $20,000 and the cost basis is $45,000, the result is a long-term capital loss of $25,000.

The IRS Revenue Ruling 2020-05 states that when the settlement amount is less than the cost basis, the policy owner recognizes a long-term capital loss.

Here's a breakdown of how to calculate a long-term capital loss:

This calculation results in a long-term capital loss of $25,000, which can be used to offset gains from other investments.

Life settlement taxation of transactions completed prior to August 26, 2009 was a bit more straightforward, but still had its complexities. The amount of money paid in insurance premiums became the cost basis, and life settlement proceeds up to that amount were free of taxes.

If you had paid $64,000 in premiums on a Universal Life Policy, for example, the first $64,000 of the settlement amount would be tax-free. The difference between the cash surrender value and the premiums paid, however, was treated as ordinary income.

The cash surrender value of $70,000 minus the premiums paid of $64,000 equals $6,000, which would be taxed as ordinary income. This is in contrast to the newer way of taxation, where the entire settlement amount is taxed as capital gains.

Here's a quick breakdown of the old way of taxation:

Taxation Policies can be complex, but let's break it down. You may have to pay state taxes on your Life Settlement, depending on where you live and your state's tax rates and policies.

Some states don't have a special tax rate for capital gains, so that amount may get taxed as ordinary income. Other states may offer special tax treatment for capital gains, lowering the tax rate.

A handful of states don't have an ordinary income or capital gains tax, so residing there means you don't pay any Life Settlement state taxes. It's best to consult with a tax professional to ensure you're paying all the right state taxes.

Here's a breakdown of how life settlements are taxed: The amount of premiums you pay into your policy are tax-free.The amount above the premiums paid into your policy up to the cash surrender value is taxed as ordinary income.Any amount above your cash surrender value is taxed as capital gains.

Federal taxation policies can be complex, but let's break it down in simple terms. If you've sold a life insurance policy, you may be subject to federal taxes.

The amount you've already paid in premiums on the policy, also called the cost basis, is not taxable in a life settlement sale. This means if your cost basis is $30,000 and your policy sells for $75,000, $30,000 of that profit is not taxable.

Taxable amounts are divided into three tiers: ordinary income, long-term capital gains, and tax-free. The cash surrender value of your policy minus the cost basis is taxable as ordinary income. For example, if you paid $30,000 on a policy with a cash value of $35,000, the difference of $5,000 would be taxed as ordinary income.

To determine how much of your life settlement is taxed as capital gain, subtract the amount subject to ordinary income tax from the total amount subject to tax. In this example, that would be $45,000 minus $5,000, so $40,000 of your life settlement profits would be subject to long-term capital gain taxes.

Here's a breakdown of the federal taxes you might owe:

Keep in mind that the amount you owe in taxes depends on the applicable tax rates and your tax bracket. It's always a good idea to consult with a tax professional to ensure you pay all the necessary federal taxes in the right amounts.

State taxes on a Life Settlement can be a bit complex. Any state taxes depend on where you live and your state's tax rates and policies.

Some states don't have a special tax rate for capital gains, so that amount may get taxed as ordinary income. This can make a big difference in how much you end up paying.

Other states may offer special tax treatment for capital gains, lowering the tax rate. This can be a huge relief for those who sell their Life Settlement.

A handful of states don't have an ordinary income or capital gains tax, so residing here means you don't pay any Life Settlement state taxes. This is definitely a perk for those who live in these states.

Long-term capital gain policy can be a complex topic, but let's break it down. If a term life insurance policy is sold, 100% of the life settlement proceeds should be treated as a capital gain, according to the IRS Guidelines.

The computation of overall tax liability is straightforward: subtract the cost basis from the settlement amount. For example, if a term policy with a death benefit of $500,000 is sold for $70,000, and premiums paid into the policy were $15,000, the overall tax liability would be $55,000.

This means that the entire amount is taxed at the policy owner's long-term capital gain tax rate, with no ordinary income tax component. The same principle applies to other types of life insurance policies, such as universal life policies.

Here's a comparison of the tax treatment for different types of life insurance policies:

In the case of universal life policies, if the cash surrender value is greater than the premiums paid, the difference is taxed as ordinary income. For example, if a universal life policy with a death benefit of $1,000,000 is sold for $90,000, and premiums paid into the policy were $64,000, with a cash surrender value of $70,000, the ordinary income tax component would be $6,000.

The balance of $26,000 would be taxed at the policy owner's long-term capital gain tax rate. This highlights the importance of understanding the specific tax implications of different life insurance policies.

If you're considering a life settlement, it's essential to understand the tax consequences. In two specific circumstances, often referred to as a viatical settlement, the sale of a life insurance policy can be received entirely free from income tax.

A "terminally ill individual" is defined 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. This certification is crucial in determining tax-free status.

If you're a "chronically ill individual" or a "terminally ill individual", the sale proceeds will be taxed as if the life insurance company had paid the death benefit.

If you're considering a life insurance policy sale, it's essential to understand the tax consequences. In some cases, the sale of a policy by a chronically or terminally ill individual can be received entirely free from income tax.

The sale price is treated as an amount paid under the policy by reason of the death of the insured, which means the sale proceeds are taxed as if the life insurance company had paid the death benefit. This can provide significant financial relief.

A terminally ill individual is defined 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 date of certification.

A chronically ill individual is someone who has been certified by a licensed healthcare practitioner as unable to perform at least 2 activities of daily living for a period of at least 90 days due to a loss of functional capacity, or has a similar level of disability.

Here's a breakdown of how life settlement proceeds are taxed:

For example, if you receive $100,000 in life settlement proceeds for a policy that you paid $30,000 in premiums toward and had a cash surrender value of $50,000, the first $30,000 would be considered your tax basis and would be tax-free.

If you're not eligible for a life settlement or not interested in selling your life insurance policy, you may have alternative options to raise cash from your life insurance policy.

These options generally apply to permanent life insurance policies, such as universal life or whole life insurance, rather than term life insurance.

Borrowing against your policy, known as a policy loan, is one option. Policy withdrawals, either full or partial, are another.

Policy loans and withdrawals are generally tax-free.

An Accelerated Death Benefit is another option, but you need to have a policy with this rider or endorsement included.

Tax deductions can be a significant advantage for life settlement policy owners.

The IRS allows for a deduction of the policy's cash surrender value, which can be a substantial amount.

Life settlement policy owners may also be eligible for a deduction of the policy's death benefit.

This can be a particularly valuable deduction, especially for individuals who have a large policy with a high death benefit.

Viatical settlements and life settlements are two distinct financial options for policyholders with a terminal illness.

Viatical settlements involve selling a life insurance policy to a third party for a lump sum payment, usually 50-70% of the policy's face value. This option is typically chosen by policyholders with a short remaining life expectancy.

Life settlements, on the other hand, are similar to viatical settlements but are available to policyholders of any age. The payout for a life settlement is usually 10-30% of the policy's face value.

In both viatical and life settlements, the policyholder receives a lump sum payment, but the key difference lies in the policyholder's age and life expectancy.

A Life Settlement is an alternative to letting your policy lapse or surrendering it for the cash value. You sell your life insurance policy to a third party for a cash payout, typically more than the policy's cash surrender value but less than the death benefit amount.

The buyer becomes the policy owner, takes over remaining premium payments, and receives the death benefit. You receive a cash settlement, which can be used for various reasons, such as increasing your retirement fund or covering medical expenses.

Life Settlements are not new, but they gained momentum in the 2000s. The market began in the 1980s, initially catering to young, terminally ill policy owners who needed to cover healthcare expenses. This led to the development of Viatical Settlements, which paved the way for other policy owners to sell their life insurance.

Here's a breakdown of how Life Settlement taxation works for different types of policies:

The key takeaway is that Life Settlement taxation varies depending on the type of policy. Understanding these rules can help you make informed decisions about your life insurance policy.

Life settlement taxation can be complex, but understanding the different approaches can help you navigate the process more easily. The IRS considers a life settlement to be a taxable event, and you'll need to report the gain on your tax return.

The IRS allows life settlement proceeds to be taxed as capital gains, which can be beneficial for some sellers. This is because capital gains are typically taxed at a lower rate than ordinary income.

The tax treatment of a life settlement depends on the type of policy being sold. If the policy is a modified endowment contract, the proceeds will be taxed as ordinary income. This can result in a higher tax liability, making it less appealing to some sellers.

In some cases, the IRS may consider a life settlement to be a taxable event, even if the policy is sold for less than its face value. This can be a surprise to sellers who are not prepared for the tax implications.

A life settlement can also be subject to state and local taxes, in addition to federal taxes. This can increase the overall tax liability, making it essential to factor in these additional costs when considering a life settlement.