May 6, 2023
Life Settlement Taxation: What You Need to Know
Are you considering selling your life insurance policy in a life settlement transaction (also sometimes referred to as a life insurance settlement)? If so, it is important as the policyholder to understand the tax consequences of such a policy sale.
As with any important financial planning decision that involves taxation, you should consult with your financial advisor, accountant, or attorney to address your specific situation. Below is a review of the general guidelines of taxation related to selling a life insurance policy in a life settlement.
What is a Life Settlement?
The sale of a life insurance policy in the secondary market is known as a life settlement. The life settlement market is an excellent option to a policy lapse or a surrender for cash value for those who qualify. When you sell a policy in the life settlement market, you will always receive an amount greater than the cash surrender value (if there is any) but less the policy’s death benefit.
The value of your life insurance policy in a life settlement depends on the specifics of your policy, the projected future premium payments, and your life expectancy.
Life Settlement Taxation
The sale of a life insurance policy potentially subjects the life settlement proceeds to tax liability. Life settlement taxation requires that you make several calculations and gather policy information, but the rules were clarified in the Tax Cut and Jobs Act of 2017 (TCJA). The rules clarification in the TJCA replaced the previous IRS revenue ruling that was more adverse to policy owners.
Life settlement tax treatment is calculated in three different tiers:
- “Return of Basis” / Principal Tier. The first item that needs to be reviewed is what is your “cost basis” in your life insurance policy. Under current IRS guidelines, your basis in the policy is equal to the total amount of premiums that you have paid into your life insurance policy. Your proceeds in the sale of your policy, up to your cost basis, are tax-free and not subject to taxation.
- Ordinary Income Tier. The second calculation covers any proceeds received that are greater than the “basis” up to the cash surrender value of the policy. This amount, if any, is taxable income at your ordinary income rate.
- Capital Gains Tier. The final tier is any amount remaining above the basis and cash surrender value. This amount, if any, is taxed at the long-term capital gains rate.
Here is an example to consider:
Life insurance policy death benefit = $100,000
Policy cash surrender value = $7,000
Policy “cost basis” = $5,000
Life settlement sale amount = $20,000
In this example, the total amount of $20,000 received by the policy seller would follow the tiers above as follows:
- Tier 1 = Return of Basis: the seller would have no taxes due on the amount of the basis ($5,000) and these funds would be tax-free (explained in #1 above).
- Tier 2 = Ordinary Income: the seller would owe ordinary income tax on the amount of proceeds received greater than the policy basis up to the cash surrender. In this case, that amount subject to ordinary income tax would be $7,000 (cash surrender value) – $5,000 (policy cost basis) = $2,000. The $2,000 would be subject to whatever the seller’s ordinary income tax rate (federal, state, and/or local) is.
- Tier 3 = Capital Gains: the seller would have a capital gains tax due on the remaining life settlement proceeds, calculated as the sales proceeds received above the cash surrender value. In this example, the seller would owe $20,000 (total sales proceeds) – $7,000 (cash surrender value) = $13,000. The $13,000 would be subject to taxes at the long-term capital gains rate (federal, state, and/or local).
So, in total, the policy seller in this example would owe ordinary income tax on $7,000 – $5,000 = $2,000 x ordinary tax rate, and capital gains tax on $20,000 – $7,000 = $13,000 x capital gains rate.
For more in-depth rules and guidelines, you can refer to the IRS website for additional details on the taxation of life settlement sales proceeds. Keep in mind that the analysis above relates to federal income taxes. If you live in a state that taxes income, like New York or California, you may also have a state income tax liability on top of the federal income tax.
Tax Basis Information Will Be Provided
As part of the TCJA, the two key parties involved in the life settlement are required to provide you with the information you need to calculate your tax liability. Here is what you should look for:
- 1099-LS: the life settlement provider will send you IRS form 1099-LS, a 1099 specific to a life settlement transaction. Keep in mind that the 1099-LS will come from the life settlement provider, not a life settlement broker. The life settlement provider is the company that you signed the life insurance contract sales agreement with to sell your policy.
- Premium Payments: the life settlement provider is also required to send a 1099-LS, for informational purposes, to the life insurance company that issued your life insurance policy. In turn, the insurance company is required to send you a statement of your total premiums paid (i.e., your total cost of insurance since you purchased your life insurance policy).
If you do not receive these documents after you sell your life insurance policy, you should make sure to contact either your life settlement provider, life settlement broker, and/or the insurance company. Remember, you should always consult with your accountant, financial advisor, or tax advisor when making an important financial decision to ensure that you understand the income tax implications.
Realities of Life Settlement Taxes
In most life settlement transactions, the amount of taxes due is minimal. The reason is that the longer the policy has been in place, the more “use” of the insurance you have had (meaning, you have had the protection of the life insurance policy). That makes it less likely that the life settlement proceeds will be greater than the amount of premiums that have been paid since purchase.
The two main exceptions are if the policy has not been in place for much time, typically five years or less, or you have had a significant change in your health. It is important to understand that every policy is different, so your situation may be different.
Taxation of Non-Sale Options with Life Insurance
If you are not eligible for a life settlement or decide that you are 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 policy (universal life, whole life, etc.) rather than term life insurance.
These alternative options are generally tax-free and include borrowing against the policy (policy loan) or policy withdrawal (either full or partial withdrawal). Again, these options are generally not available with a term policy.
Another potential option to get cash out of your policy without a sale is called an Accelerated Death Benefit. First, you need to make sure that your policy has an Accelerated Death Benefit rider or endorsement included. Second, you need to meet certain health requirements, typically, you need to have a chronic or terminal illness. If you do have access to this option, your proceeds can be up to 50% of the death benefit and are not subject to taxation.
It is important to point out that the taxation of a viatical settlement may be different than the treatment of a life settlement. Please refer to our resource for more information about the difference between a life settlement and viatical settlement. Viatical settlement transactions typically involve a policy seller that has either a chronic or terminal illness.
The tax consequences of a life settlement transaction are important to understand before you make the decision to sell your life insurance policy. This article is meant to be a general guide on the taxation, but you should make sure to consult with your trusted advisor as part of your sales decision-making process.
You can get an instant estimate of the value of your life insurance policy by visiting the Q Life Settlements calculator. You can also call Q Life Settlements at 866-679-9410, contact us here, or email us email@example.com to discuss your situation. Our team is available and ready to explain to you all that you would want to know about life settlements.
Remember: Never abandon a life insurance policy without looking at the life settlement option first!
Author: Steven Shapiro
Steven Shapiro is the founder of the Company and also the President and CEO of Q Capital Strategies, LLC and Life Settlement Solutions LLC. Steven has been active in the life settlement industry for the last 18 years. In addition to his life settlement experience, Steven has expertise in strategic consulting, investment banking advisory services, and private equity investing. Steven holds a B.A. degree in economics from the University of Pennsylvania and an M.B.A. in finance and entrepreneurial management from The Wharton School of the University of Pennsylvania. Steven is also the immediate past Chair of LISA (having previously served as Chair), the Life Insurance Settlement Association, the oldest and largest trade organization in the life settlement industry.