Life Settlements can provide large payouts, making them ideal options for life insurance policy owners wanting to turn their policies into liquid assets. With such a big transaction comes the potential for associated taxes. When considering whether a Life Settlement is right for you, remember to think about the possibility of paying taxes on your settlement payout and discuss the possible tax implications with your tax professional. Knowing how Life Settlements are taxed is an essential aspect of understanding Life Settlements as a whole.
Learn how Life Settlements are taxed and how to estimate the taxes on your settlement.
Life Settlements are an alternative to letting the policy lapse or surrendering your policy for the cash value from the insurance carrier. A Life Settlement involves selling your life insurance policy to a third party for a cash payout in excess of the policy’s cash surrender value. Life Settlement payouts are typically more than the policy’s cash value and less than the death benefit amount.
Your Life Settlement purchaser becomes the policy owner, and you receive a cash settlement. The buyer takes over any remaining premium payments when you sell your life insurance, and they become the beneficiary and receive the death benefit.
Life insurance policy owners sell their policies for various reasons, most often because they need extra cash. Whether you want to increase your existing retirement fund or need to cover medical-related expenses, a Life Settlement is an effective way to get value out of your policy. The cash payout from Life Settlements is typically relatively large compared to the surrender value, so be sure to consider a Life Settlement before surrendering your policy.
The option to sell your life insurance policy in a Life Settlement is relatively new, only gaining momentum in the 2000s. After the Supreme Court deemed life insurance personal property in 1911, the Life Settlement market began in the 1980s during the height of the AIDs epidemic. Young, terminally ill policy owners needed more options to help cover their healthcare expenses, creating a market for Viatical Settlements. As the market for Viatical Settlements grew, it paved the way for other policy owners to sell their life insurance.
Given the relatively short history of Life Settlements, the IRS was initially indecisive and even silent regarding how to tax Life Settlement transactions. Their initial ruling went into action in 2009 and was replaced in 2017, which is the current ruling in Life Settlement taxation. The initial Life Settlement taxation ruling was complicated and confusing for both policy owners and tax professionals.
The Tax Cuts and Jobs Act of 2017 (TCJA) significantly simplified Life Settlement taxation. With this act, the IRS redefined Life Settlement profits and how the cash payouts should be treated. TCJA still applies to Life Settlement taxation today, so calculating your taxes for Life Settlements is much more comprehensible.
When considering whether a Life Settlement is the right choice for you, remember it’s a major asset sale and is likely subject to federal and state taxes. The amount you may have to pay in taxes depends on the amount you’ve already paid in premiums on the policy and how much you get from the settlement. The types of taxes you may pay depend on the cash surrender value and settlement amount. Generally, the more premiums you’ve paid on the policy, the lower your Life Settlement taxes will likely be.
Life Settlements can be federally taxed in three ways or tiers:
Putting this example together, your federal taxes would be as follows:
The amount you owe in taxes depends on the applicable tax rates and your tax bracket. In this example, your taxable capital gains amount is less than the minimum tax bracket, so it would be tax-free. It’s important to emphasize that every Life Settlement is different, and tax rates are constantly fluctuating, so it’s best to consult with a tax professional to ensure you pay all the necessary federal taxes in the right amounts. Please consult with your tax advisor about your specific situation.
In addition to federal taxes, you may have to pay state taxes on your Life Settlement. Any potential state taxes depend on where you live and your state’s tax rates and policies. For example, 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 here means you don’t pay any Life Settlement state taxes.
Again, it’s best to consult with a tax professional to ensure you’re paying all the right state taxes on your Life Settlement.
Your health status and type of Life Settlement can also affect what you pay in taxes. While good health status results in a standard Life Settlement, terminally or chronically ill policy owners wanting to sell their life insurance policies would get a Viatical Settlement. By IRS standards, terminally ill refers to an individual with a life expectancy of two or fewer years. Because terminally ill policy owners typically want a settlement to use the money for healthcare costs, Viatical Settlements are generally tax-free, regardless of the sale price, cost basis, and cash surrender value.
Viatical Settlements are considered an advance on your policy’s death benefit, while standard Life Settlements are capital gains and ordinary income. This is why Life Settlements are taxable, and most Viatical Settlements are tax-free.
Deciding on a Life Settlement is a big decision, and there’s much to consider when determining if it’s the right financial choice for you. As such, you likely have more questions about Life Settlements and the associated taxes. Find the answers to more common Life Settlement questions here.
Whether you have to pay taxes on your Life Settlement depends on how much you’ve paid in life insurance premiums, the settlement value, and the policy’s cash surrender value. In most cases, a portion of your settlement is subject to federal taxes. If your Life Settlement is taxed, you must pay the associated taxes. Failure to pay taxes results in additional fees and tax evasion repercussions.
As the Life Settlement payment recipient, you’ll file your settlement federal taxes using IRS Form 1099-LS. After filling out the form, you can mail the form and a check for the amount you owe in federal taxes to the IRS. Paying your state settlement taxes will depend on how your state handles settlement taxes. A tax professional can help you determine how to file taxes for your situation properly.
A life insurance policy’s cash surrender value is the amount of money you’d receive from your insurance provider if you ended your policy. Cash values are features of permanent life insurance policies in which your premiums pay for your insurance and fund a cash account. When you surrender your life insurance policy, the cash value is withdrawn, and you receive the payout in exchange for canceling your death benefit. Surrendering your policy typically involves policy termination fees.
Despite being subject to federal and state taxes, Life Settlements are worth paying taxes on for most people. Life Settlements provide significantly higher payouts than cash surrenders, so many people are willing to pay the tax for a higher payout.
In some cases, Life Settlements can be tax-free. For example, many Life Settlements aren’t federally taxed because the cost basis exceeds the settlement payout value. You may also receive a tax-free Viatical Settlement. However, in most other cases, expecting to pay taxes on your Life Settlement is best. Taxes are simply part of the process, and there’s no legal way to avoid them when receiving a Life Settlement.
Selling your life insurance policy is a significant decision, and working with the right broker can make a big difference in how much you get for your policy. At Settlement Benefits Association, we represent you as the policy owner in selling your life insurance policy. We help you find a buyer with the best offer to get the best value for your policy. We truly value you as a client and understand you may need help navigating the Life Settlement process.