Understanding Life Settlement Taxes

Rebecca Parson
Rebecca Parson

Rebecca Parson

Author

Rebecca Parson is a financial and tech writer with 10 years of experience writing about topics such as life insurance, commodities investing, and the SaaS industry. She has a master’s degree from Johns Hopkins University and a bachelor’s degree from the University of Mary Washington. Her writing has appeared at money.com, sacbee.com, cart.com, herodevs.com, blanchardgold.com, and more.

Brian OConnel
Brian OConnel

Brian O'Connel

Contributor

Brian O’Connell has been a contributing writer for U.S News & World Report since 2016. A former Wall Street bond trader and the author of two best-selling books; “The 401k Millionaire” and “CNBC’s Creating Wealth”, he has 20 years experience covering business news and trends, particularly in the business and financial sectors. He believes education is the best gift a financial consumer can receive – and brings that philosophy to every story he writes. His byline has appeared in dozens of top-tier national business publications, including CBS News, Bloomberg, Time, MSN Money, The Wall Street Journal, CNBC, TheStreet.com, Yahoo Finance, CBS Marketwatch, and many more.

By Rebecca Parson, Brian O'Connel
Author, Contributor, Life Insurance

Are Life Settlements Taxed?

We’ll start with the simple answer most people are looking for. In the vast majority of life settlements, there are minimal (or no) taxes due on the proceeds of the settlement.

life settlement taxes

One of the most common questions we hear from people considering a life settlement is “What about taxes?” 

It’s a good question, and it’s important to know how much of your settlement proceeds you might have to pay as taxes. In fact, many people are hesitant to consider a life settlement at all because they’re worried about getting stuck with a major tax bill.

Thankfully, we can shed some light on the most common outcomes—and most of them are great news for you! Keep reading for everything you need to know about how life settlement taxes.

Why? There are a few reasons, but the most important has to do with the revision of the tax code in 2017 in an update called the “Tax Cuts and Jobs Act of 2017.” The revision fundamentally changed—and greatly simplified—the tax treatment of life settlements.

Under the code, there are two primary reasons a life settlement would NOT be taxable. Here’s what you need to know about those two situations. 

  • A life settlement is only taxable to the degree that it exceeds the total premiums paid on the policy since the policy was purchased. (The IRS defines this difference as your “profit.”)

For Example:

If an individual, say Mr. Smith, took out a $500,000 policy in 2009 and paid $5,000 per year in premiums, he would have paid a total of $75,000 since purchase. If Mr. Smith goes to sell that policy in 2024, the first $75,000 of the proceeds (matching his payments so far) would be tax-free.

So, if his total settlement amount is $100,000, he would only be taxed on $25,000. If you’re more of a visual learner, here’s how that would break down in a chart. 

Face Amount$500,000
Premiums Paid$75,000
Settlement Amount$100,000
Taxable Income$25,000

Those taxes would also likely be minimal as they’re almost always taxed as long-term capital gains—more on that below. 

  • The viatical exemption establishes that the entire proceeds of the life settlement are tax-free (regardless of premiums paid into the policy) if a doctor estimates the life expectancy of the insured at less than 24 months.

Why? The IRS views a viatical as an advance on the death benefit of the policy. As a result, it gets the same tax treatment as the death benefit, which is exempt from taxes altogether. This helps relieve the burden of taxes on families who are already going through a difficult situation with a loved one. While this applies to all life insurance policies, this exemption is particularly important with term life insurance policies since the cumulative premiums paid tend to be lower.

There’s one more loophole here: if the insured has a life expectancy greater than 24 months but is dependent on others for two or more activities of daily living (i.e., the insured is chronically ill), the portion of the settlement used for care of the insured is also not taxed. That amount can be used as a write off. 

The Old Tax Code and Common Myths for Life Settlements

As we emphasized above, the Tax Cuts and Jobs Act of 2017 marked a significant change in the treatment of life settlements. The updated tax code streamlined a series of complicated terms that spanned from 2009 to 2017, which had been confusing many insured individuals for years.

If you’ve heard that life settlement proceeds are heavily taxed, that your life settlement proceeds would be taxed exclusively at your ordinary income tax rate, or that life settlement proceeds would be taxed especially differently than “policy surrenders,” you’re getting outdated information. Those are all scenarios from the old tax code, and all were—thankfully—updated in 2017.

The bottom line? If you’re not confident in the source of your information, make sure to verify with a trusted professional. There is a lot of well-intentioned misinformation out there, and many people who have dealt with life settlement proceeds in past years don’t understand the current landscape. Unless your information is tied to the Tax Cuts and Jobs Act of 2017, it’s likely inaccurate.

Life Settlement Tax Treatment

With all that in mind, let’s explore what happens to the proceeds from a life settlement that are subject to taxes.

When life settlement proceeds are taxed, they’re most often taxed as long-term capital gains. For most people, this is good news: instead of paying your regular income tax rates, a life settlement would be taxed at a rate of 15% across the board (or, in rare cases, up to 20%).

For Example:

If we revisit our previous example with Mr. Smith, you can see how minimal the tax obligation is for many people. (As we established above, Mr. Smith’s settlement leaves him with $25,000 that’s taxable.)

Let’s assume Mr. Smith is married and earns $75,000 a year. In that case, the total tax obligation on his $100,000 settlement is essentially nothing; his tax bill will remain effectively the same before and after the settlement. In either case, he can expect to pay about $5,000.

If we change the scenario and Mr. Smith gets $200,000 from his settlement instead of $100,000 (bumping the taxable amount from $25,000 to $125,000), his taxes would increase by approximately $10,000 total. That comes out to about 5% of the total settlement amount.

Should You Be Worried About Life Settlement Taxes?

As with all tax-related matters, everyone’s situation is a little different. If you have specific questions related to your specific situation, please reach out to a competent tax professional. 

In general, though, the bottom line is simple. For most people, taxes should not be a factor in deciding whether or not to proceed with a life settlement. 

Less Common Situations Where Taxes Affect Life Settlements

While the answers above will apply to the vast majority of people, there are some situations in which the taxes on a life settlement can be significant.

These outcomes typically involve very high face-value policies or relatively new policies in which the health of the insured deteriorated rapidly after the policy was purchased. 

It’s also possible (but rare) for a portion of the settlement to be taxed as regular income rather than capital gains. This can occur when the cash value of the policy exceeds the total premiums paid. The portion of the cash value that exceeds the premiums paid is taxed as regular income.

Thankfully, we don’t see this situation often, but it is an outcome to be aware of as a rare possibility. In general, it only occurs with front-loaded policies (policies that have significant amounts of money put in in the early years) that are being used as a tax shelter for the interest on the money invested. 

Even in these situations, there are strategies to mitigate your tax burden and make the outcome as favorable as possible. Talk to a tax professional to understand how to best approach this situation if you think this may be an issue that relates to you. 

Transferring Your Life Settlement Policy to Avoid Tax Liability

If you’d like to avoid the tax liabilities altogether (and you can’t or no longer want to pay your premiums), you can also opt for a less attractive option of transferring the life insurance policy.

If a loved one or a relative takes over the policy, the new owner receives the full face value of the policy when it matures without any tax liability. This can benefit a relative, a friend or a charity as long as they did not pay for the transfer of the policy. The IRS views any payment for a life insurance policy as a life settlement and the proceeds of the maturity will be taxed as any investor would be.

While this doesn’t financially benefit the insured, it does give the insured other options and can help keep the future benefit in the family. If you’re interested in this option, make sure to consult with a tax professional to ensure that everything is done correctly so that the death benefit will be tax free.

Understand That You Have Options

Ultimately, understanding the tax implications of your life settlement is a critical step for your financial future. 

No one wants to face an unexpected tax bill, but the current legal environment is set up for you to use life settlements to your advantage. A high tax burden is a rarity, even for individuals who are heavily taxed on income and other investments.

As always, we’re happy to discuss your specific situation to provide more tailored guidance. It’s always worth understanding exactly what your life settlement can provide for you, and that includes a clear picture of what your tax obligation may look like. 

If you’d like to chat about your unique situation, contact us here to schedule a time to connect.

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