Many policy owners assume that selling a life insurance policy automatically triggers a large tax bill. In reality, life settlement taxation is layered. Some of the proceeds may be taxable, while other portions are often excluded altogether. But in the end, chances are you’ll owe less in taxes than you think.
Let’s take a closer look at life settlement tax implications to help clarify what’s taxable, what’s not and why outcomes vary.
ARE LIFE SETTLEMENT PROCEEDS TAXABLE?
Generally, the portion of life settlement proceeds that’s greater than what you’ve paid into the policy is taxable. On the other hand, the amount that equals what you’ve paid in premiums isn’t. For tax purposes, it’s treated similarly to a refund of your money.
An exception may be if you deducted premiums as a business expense, such as may happen with employer-owned or business-owned policies. You may have to pay taxes on your proceeds for the equivalent in deducted premiums.
HOW LIFE SETTLEMENT TAXES GENERALLY WORK
How much you have to pay in life settlement taxes typically depends on three factors: your cost basis, the policy’s cash surrender value and the final settlement amount. These factors also relate to the three possible tax portions of your life settlement proceeds. Let’s look at the possible taxes in more detail.
Cost Basis
Your life insurance cost basis generally isn’t taxable. It’s the total premiums you’ve paid into the policy. Your cost basis is often excluded from your final settlement proceeds as taxable income.
Cash Surrender Value
If your policy’s surrender value is higher than your total premiums paid, then the difference between the two is usually taxed as ordinary income.
For example, if the insurer calculates your policy’s surrender value as $11,000 and you’ve paid $10,000 in premiums so far, the $1,000 difference is treated like regular income for tax purposes. This amount is taxed the same way if you choose to surrender the policy instead, because the $1,000 represents a growth in the policy’s value.
It can take decades for a policy’s cash surrender value to exceed its cost basis. Cash value growth, surrender fees and outstanding loans and interest are used to calculate your policy’s surrender value.
Remaining Proceeds
Any remaining life settlement proceeds beyond the cash surrender value are usually taxed as a capital gain rather than ordinary income. Most people who sell policies in a life settlement have held their policy for more than a year, so they’ll pay long-term capital gains instead of short-term capital gains.
There are only three long-term capital gain tax brackets: 0%, 15% and 20%. Your bracket depends on your income and filing status.
The Three Possible Taxes in Action
Say you’ve paid $50,000 in life insurance premiums over time, and your policy has a cash surrender value of $60,000. You decide to sell your policy and receive $100,000 in a life settlement after deducting life settlement broker fees or other costs.
Here’s the tax treatment you could see.
- Life settlement cost basis: $50,000 → Generally tax-free
- Cash value over cost basis: $10,000 ($60,000 – $50,000) → Taxed as ordinary income
- Remaining proceeds over cash value: $40,000 ($100,000 – $60,000) → Taxed as long-term capital gains
WHEN LIFE SETTLEMENT TAXES MAY BE MINIMAL OR REDUCED
Given how life settlement proceeds are taxed, you may see little to no taxes when your proceeds are similar to your cost basis because they mainly return your original premium payments. The longer you’ve paid into your policy, the less you’re likely to owe in taxes on your proceeds.
3 COMMON TAX MYTHS ABOUT LIFE SETTLEMENTS
While the tax structure of life settlements is relatively straightforward, there are a few common misconceptions.
Myth: Life settlement proceeds are completely tax-free.
Fact: Your life settlement proceeds are generally only tax-free when your cost basis is the same as or more than what you sell the policy for. Your cash surrender value should also be equal to or less than your cost basis to pay little to nothing in income tax on it.
Myth: When it comes to life settlement vs. surrender taxes, there’s no difference in how much you’ll pay.
Fact: Whether you sell or surrender a policy, the difference between your cash surrender value and cost basis is taxed as ordinary income. In this instance, the life settlement proceeds tax treatment is similar to that of a policy surrender.
Where tax treatment varies is with the capital gains tax. Capital gains taxes aren’t applicable with a policy surrender. Only proceeds above the cash surrender value are taxed as capital gains, and insurers won’t pay you more than your surrender value when surrendering a policy.
Myth: Taxes make life settlements not worth it.
Fact: Even if you have to pay capital gains tax on a life settlement, you’re likely still walking away with more money than a policy surrender.
In our earlier example, you’d have at least an extra $32,000 in your pocket ($40,000 remaining proceeds after cash value x 20% capital gains tax = $8,000 in taxes) when compared to surrendering, even after applying the highest capital gains tax bracket.
WHY SENIORS SHOULD TALK TO A TAX OR FINANCIAL PROFESSIONAL
A life settlement is a financial decision that should be evaluated against broader financial and legacy goals. Before selling or surrendering your life insurance policy, it’s important to consult with a CPA, financial advisor or estate planning professional to see what the implications for you and your loved ones are. Life insurance settlement IRS rules and your personal tax situation can affect your final tax liability, so it may be different than the numbers we’ve presented in this article.
LIFE SETTLEMENT TAXES MAY BE LOWER THAN YOU THINK
Many seniors who wonder, “Are life insurance settlements taxable?” are surprised to learn that only a portion of the proceeds may be taxable. Even with any taxes owed on proceeds, selling a policy via a life settlement is often more tax-efficient than surrendering it. How much you pay in taxes depends on the policy’s cost basis, premiums paid and the amount received.
Once you know the basics about how life settlements are taxed, you can make a more informed decision about what to do with your policy. Consulting with a tax advisor can help clarify any remaining tax questions.
If you want to know more about selling your policy or have questions about the process, reach out to Life Settlement Advisors today. We’re happy to review your policy for free and help you evaluate your options.
