Did you know you can sell all or a portion of a life insurance policy, even term insurance?
(3 minute read)
When someone is considering selling a life insurance policy, one of the most frequently asked questions is “Will I pay taxes on this?” The short answer is yes, there can be taxable gains on life insurance policies under certain circumstances, but only on a portion of the payout. Each policy is different, and you should always consult a financial advisor before making any big financial decisions to know what to expect for your specific situation. Let’s go through the basics to give you an idea of what to expect.
Do You Pay Taxes on a Life Insurance Cash Out?
Yes, you do pay taxes on a portion of a life insurance cash out in most situations. Below is a list of the most common ways to cash out a life insurance policy, and what the tax ramifications are likely to be:
- Policy owner dies and heirs receive proceeds – no tax
- Policy owner surrenders policy for less than they paid into it – no tax
- Policy owner sells policy as a viatical settlement due to terminal illness – no tax
- Policy owner sells policy as a life settlement – tax only on amount above what was paid in premiums
What Part of the Surrender Value Would Be Income Taxable?
If you choose to sell or surrender your life insurance policy while you are still living, only the portion of the money beyond what you paid into the policy would be taxable. It is important to keep in mind that selling a policy and surrendering a policy are two different things.
Surrendering a policy is typically done to the insurance provider. The cash surrender value amount is pre-determined by the insurer, and this surrender value is typically similar to or less than the amount of money you paid into the policy.
Selling your life insurance policy, on the other hand, is not done with your insurer but with a third party like Life Settlement Advisors. Typically, the return on a life settlement will be significantly above the amount you paid into the policy.
With this difference in mind, it makes sense that little or none of the surrender value of a policy is taxed, because you receive a similar amount or less money then you paid in. Since it was your money you were putting in after taxes, and it didn’t grow much, there is little to nothing to pay taxes on.
If you sell your life insurance in a life settlement, though, you can receive considerably more money than you paid in, and this “extra” money is the only portion that would be taxable. For example, if you paid $500 per year for 20 years into your life insurance policy, you paid a total of $10,000. If you sell your policy for $25,000, the $10,000 you paid into it is not taxable, but the extra $15,000 you received on top of that would be taxable.
How Much Tax Do You Pay on a Life Insurance Payout?
Calculating the exact taxable gains on life insurance policies is complicated and will vary for each specific case and by the tax bracket of the person selling the policy. We highly recommend consulting a tax professional to understand your exact situation. The Tax Cuts and Jobs Act of 2017 (TCJA), and IRS Revenue Rulings 2020-05 provide a basic structure on how these rates are calculated. Let’s look at an example to better understand what portion of insurance would be taxable and at what rates.
For a policy that has a stated cash surrender value from the insurance agency as part of the policy:
- Overall Tax Liability = Life Settlement Amount minus Total Amount Paid Into Policy
- From our above example: $25,000 – $10,000 = $15,000
- So if you received $25,000 and paid in $10,000, you would owe taxes on $15,000
- Ordinary Income Tax = Cash Surrender Value minus Total Amount Paid Into Policy
- If our above example policy had a cash surrender value of $11,000: $11,000 – $10,000 = $1,000
- So $1,000 of the total taxable amount would be taxed at your regular income tax rate
- Capital Gains Tax = Overall Tax Liability minus Ordinary Income Tax Amount
- $15,000 – $1,000 = $14,000
- So the remaining $14,000 of your tax liability would be taxed at your capital gains tax rate
If your policy does not have a cash surrender value, you follow the same formula but with $0 as the cash settlement value. In this case, $0 taxable amount would be ordinary income and all of the taxable amount would be assessed as capital gains.
The question is what’s the difference in tax rate between capital gains and ordinary income. In most situations, the capital gains tax rate will be less than the ordinary income tax rate, meaning you will pay less capital gains tax on life insurance payout the more of this money is considered capital gains. According to the IRS, these are the relevant tax rates in 2022 for a single person:
- Capital Gains
- 0% if your taxable income is less than $40,400
- 15% if your taxable income is between $40,400 and $445,850
- 20% if your taxable income is over $445,850
- Ordinary Income
- 10% if your taxable income is less than $10,275
- 12% if your taxable income is between $10,275 to $41,775
- 22% if your taxable income is between $41,775 to $89,075
- 24% if your taxable income is between $89,075 to $170,050
How Do I Report Cash Surrender Value on my Taxes?
To report money received from selling or surrendering your life insurance policy, you need to fill in a Form 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, available from the IRS when it is time to do your tax filing. Once you have filled out Form 1099-R, you will report the amounts calculated there on to Form 1040 U.S. Individual Income Tax Return in the specified places.
Are Death Benefits Taxable to the Beneficiary?
Generally, death benefits from a life insurance policy are not taxable. Once the policy owner has died, the money paid to the beneficiaries is not considered taxable income. This is true whether a policy owner is gifting life insurance proceeds to an heir, an unrelated individual, or a charity.
Life Settlement Advisors: Let Us Help You
Overall, the tax ramifications of selling your life insurance policy are important to be aware of so you can make the best financial decision for your situation. The main takeaway is that the only portion that will be taxable is the amount above what you paid in, so getting the most money possible from your investment will be your best strategy.
At Life Settlement Advisors, we’re here to help you get the most from your life insurance policies for your best future! We walk you through each step of the process so you know exactly what your policy is worth. Let us show you what benefits we can deliver today, reach out for a quote or contact us now!
Did you know you can sell all or a portion of a life insurance policy, even term insurance? Selling an unwanted life insurance policy is no different than selling your car, home or any other valuable asset that will create immediate cash. Contact us today to learn more.
I am always happy to answer any and all questions about these life-transforming transactions.
Life Settlement Advisors