How Your Clients Get Taxed on Sold Life Insurance
What You Need to Know
Insureds who seem likely to die within two years pay no federal income taxes on life policy sale proceeds.
For other insureds, one important factor is the total amount of premiums paid.
Another important factor is the policy surrender value.
Life insurance is generally a tax-friendly asset, thanks to the tax-free death benefit and the tax-deferred cash value growth.
Still, there are situations in which life insurance can create tax liabilities.
One of those situations is the sale of a policy through a life settlement.
Below, we’ll discuss how sold life insurance is taxed and when you might benefit from discussing life settlement taxation with your clients.
Life vs. Viatical Settlements
Two types of transactions result in the sale of life insurance: life settlements and viatical settlements.
A life settlement is the sale of life insurance by a policy owner who is not terminally or chronically ill.
The transaction is generally available to insureds aged 65 or older who no longer need or want their life coverage.
Selling an unwanted policy to a third-party investor will net more cash than surrendering the coverage back to the insurer.
A viatical settlement is the sale of life insurance by a policy owner who is terminally ill.
To qualify for a viatical settlement, a physician must certify that the insured has an expected lifespan of two years or less.
Viatical settlements typically complete more quickly and have slightly higher payouts relative to the death benefit vs. life settlements.
While the two transactions are otherwise similar, the tax treatment is not.
Taxation of Viatical Settlements
The 1996 passing of the Health Insurance Portability and Accountability Act made the proceeds from viatical settlements exempt from taxes.
As a result of HIPAA, terminally ill insureds can use the full proceeds from their settlement to pay medical bills or check items off their bucket list.
Taxation on Life Settlements
The current tax treatment of life settlements was put in place by the Tax Cuts and Jobs Act of 2017 (TCJA).
Under TJCA, taxation on life settlement proceeds follows a three-tier system:
Net proceeds up to the policy cost basis are not taxable. A policy’s cost basis is the cumulative premiums paid.
Net proceeds above the cost basis and up to the policy’s surrender value are taxed as ordinary income. The surrender value is cash value less any surrender fees collected by the insurer.
Any net proceeds beyond the surrender value are taxed as capital gains.
Net proceeds, as you’d expect, is the sale price of the policy less broker commissions and other fees related to the sale.
This means a client who’s paid $84,000 in premiums and nets $125,000 in a life settlement incurs a $41,000 taxable event.
Some of the $41,000 is taxed as ordinary income, and some is taxed as capital gains.
The exact amounts of each hinge on the policy’s surrender value.
If the surrender value is, say, $95,000, the ordinary income rate applies to $11,000, and the capital gains rate applies to the remaining $30,000.
The Need for Tax Advice on Life Settlements
Understanding the tax implications of life settlements is important when your clients have already executed the sale of their insurance.
There are more opportunities, however, to use your expertise in this area.
These opportunities can arise when a client is evaluating a potential life settlement and also before the client has considered a life settlement.
Evaluating Potential Life Settlements
The case for a life settlement can be both mathematical and emotional.
The mathematical argument involves comparing the policy’s death benefit to the projected value of life settlement proceeds if reinvested elsewhere.
Sometimes, the after-tax proceeds deployed into another asset can ultimately add more wealth to the insured’s estate than the policy’s death benefit.
In that case, the policy essentially costs more to keep than to sell.
To complete this analysis, your client needs your help estimating the tax consequences of the life settlement.
You’d also want to highlight any other outcomes—such as a temporarily higher surcharge on Medicare premiums—and assess the impact, if any, of estate taxes.
You can also contribute to the conversation for clients who lean into emotional decisions.
