Life insurance policies are supposed to provide peace of mind. However, for seniors who no longer need the coverage or can’t afford the premiums, that same policy can become a financial burden. That’s when selling the policy in a life settlement sounds like a smart move.
But most people don’t realize that a life settlement can also trigger tax consequences. And without knowing how the transaction will be taxed, you could be in for an unpleasant surprise come tax time.
This guide breaks down what you need to know about life settlement taxation, including how the IRS treats your payout, which parts are taxable and what questions to ask your CPA before you sell.
WHAT IS A LIFE SETTLEMENT, AND WHY DOES THE IRS CARE?
A life settlement is when you sell your life insurance policy to a third-party buyer for more than its cash surrender value, but less than the death benefit. It can turn an unwanted life insurance policy into real money, sometimes hundreds of thousands of dollars.
But because you’re essentially exchanging your life insurance for cash, the IRS treats that payout like a financial transaction. That means the proceeds could be subject to taxes, depending on the size of the payout and your cost basis in the policy.
The IRS sees these transactions as a combination of ordinary income and capital gains, and how your payout is taxed depends on how much you’ve paid into the policy over time and what the settlement amount is in relation to the surrender value.
HOW ARE LIFE SETTLEMENTS TAXED? (THE 3- TIER IRS RULE)
The IRS breaks a life settlement payout into three parts. Think of it like layers of a cake: the bigger the payout, the more layers may be taxed.
Here’s how it works:
1. Proceeds Up to Your Cost Basis (Not Taxable)
Your cost basis is the total you’ve paid in premiums (minus insurance costs or withdrawals). This portion of your payout is not taxed.
2. Proceeds Above Your Cost Basis, Up to the Surrender Value (Taxed as Ordinary Income)
The amount between your cost basis and the surrender value is taxable as ordinary income, similar to wages.
3. Proceeds Above the Surrender Value (Taxed as Capital Gains)
Anything beyond the surrender value is taxed as a capital gain. If you’ve owned the policy for more than one year, the IRS treats the gain as a long-term capital gain, typically taxed at 15%–20%. If you’ve owned it one year or less, the gain is considered short-term and taxed at your ordinary income rate.
- Premiums paid (cost basis): $80,000 over 20 years
- Surrender Value: $100,000
- Life Settlement Sale Price: $150,000
Tax Breakdown:
- 1. Up to cost basis ($0–$80,000) → Not taxed
- 2. Above cost basis, up to surrender value ($80,000–$100,000) → $20,000 taxed as ordinary income
- 3. Above surrender value ($100,000–$150,000) → $50,000 taxed as long-term capital gains
Tax Estimate:
- Ordinary income portion: $20,000 × 22% = $4,400
- Capital gains portion: $50,000 × 20% = $10,000
Estimated Total Tax Owed: $14,400 (Actual tax may vary based on income level, deductions and filing status.)
4. A Policy With Loans
If you have borrowed against your policy, any outstanding loan balance is deducted from the proceeds and may affect the taxable amount.
The rules aren’t complicated, but they can have a significant impact on how much money you actually keep from your life settlement. Understanding this three-part tax structure can help you plan better, avoid surprises and make sure you’re setting aside enough for tax season.
HOW LIFE SETTLEMENT TAXES WORK IN REAL SITUATIONS
Let’s look at a few examples of how life settlements taxes would work in real life situations:
Scenario 1: Selling for Less Than What You Paid In
You sell your life insurance policy for $20,000. Over time, you’ve paid $25,000 in premiums. Because the payout is lower than your total premium payments (your cost basis), the full $20,000 is not taxable.
Scenario 2: Selling for More Than the Cash Surrender Value
Let’s say your policy’s cash surrender value is $50,000, and you sell it for $80,000. You’ve paid $30,000 in premiums.
- The IRS considers the first $30,000 a return of your investment, and this is tax-free.
- The next $20,000 (the difference between the cash surrender value and your cost basis) is taxed as ordinary income.
- The final $30,000 (the amount above the surrender value) is taxed as a capital gain.
Scenario 3: Loans on the Policy
If you sell a policy for $60,000, but there’s a $15,000 loan against it, that loan amount is subtracted from the total. So you’re effectively receiving $45,000. You then calculate your taxable income based on that adjusted figure.
Your state may have its own laws that affect how a life settlement is taxed. These rules can impact how much you actually receive after taxes. That’s why it’s important to either review your state’s regulations or work with a licensed advisor who understands them.
WHEN IS A LIFE SETTLEMENT TAX-FREE?
Depending on your numbers, some or all of your proceeds may not be taxable. Let’s say:
- Total premiums paid (cost basis): $100,000
- Surrender value: $5,000
- Life settlement offer: $75,000
Now apply the IRS tax rule:
- 1. Up to the cost basis ($0–$100,000) → Not taxed
- 2. Above the cost basis, up to your surrender value ($100,000+) → Does not apply (the sale price doesn’t exceed basis)
- 3. Above the surrender value ($5,000+) → Does not apply
Result: The full $75,000 falls below the cost basis. That means you owe zero taxes.
Even small differences between your cost basis and payout can trigger income or capital gains taxes. That’s why every seller should calculate their tax exposure ahead of time.
BEFORE YOU SELL, TALK TO A TAX PROFESSIONAL
The IRS sees a life settlement as a financial transaction rather than a policy benefit. If you don’t understand how your payout will be taxed, you could end up owing more than you expected.
A tax professional can:
- Help you calculate your cost basis
- Review the surrender value
- Estimate how much of your payout will be taxable
- Explain which tax forms (like Form 1099) you’ll receive
- Confirm whether you can offset the gains with losses elsewhere
Life Settlement Advisors helps you evaluate your policy and navigate the process, but we do not provide tax advice. Only your CPA or advisor can give you a complete picture of your tax obligations.
KNOW THE TAX RULES BEFORE YOU CASH OUT
A life settlement can create liquidity, but the tax rules are layered and easy to overlook. If you’re thinking about selling your life insurance policy, review your cost basis, ask your advisor for guidance and seek help to understand how life settlement taxes may apply.
Ready to start the process of selling your policy? Contact Life Settlement Advisors today.
