Life settlements and taxes: Navigating the complexities

By William Scott Page

At this time of the year, seniors, life insurance agents, financial advisors and accounting professionals find themselves immersed in the intricacies of tax preparation. Amid this financial journey, questions about the taxation of life insurance settlements often arise.

Although it's advisable to seek guidance from a tax professional, let's explore the fundamentals with a clear and informative perspective.

Chapter 1: Understanding life settlements

Life insurance settlements can be categorized into two types.

Viatical settlements: These are designed for people with terminal illnesses, with a prognosis of dying within 24 months. The IRS provides special tax treatment for these cases, resulting in tax-free proceeds. It's a silver lining for individuals in challenging circumstances.

The IRS defines a terminally ill person as someone with a certified medical prediction of dying within 24 months. Additionally, for those who are chronically ill and require substantial assistance with daily activities, their settlement proceeds may also remain untaxed.

Traditional life settlements: In contrast to viatical settlements, traditional life settlements typically involve individuals who are not terminally ill but are looking to sell their life insurance policies for cash. The insured individual may be elderly or have certain health conditions, but their life expectancy is typically longer than 24 months. Traditional life settlements do not qualify for the same tax benefits as viatical settlements and are subject to regular income tax on the proceeds.

Now, let's delve into traditional life settlements, where taxes play a more significant role.

Chapter 2: Taxation in classic life settlements

Taxes in classic life settlements are divided into tiers.

First tier (tax-free): Proceeds equal to your tax basis remain exempt from taxation. This includes the total premiums paid. For example, if your settlement amount is $100,000 and your tax basis (total premiums) is $50,000, the initial $50,000 remains tax-free.

Second tier (ordinary income tax): Proceeds exceeding your tax basis but falling below the policy's cash surrender value are subject to ordinary income tax. For example, if your policy's cash surrender value is $80,000, and your basis is $50,000, the next $30,000 is considered ordinary income.

Third tier (capital gains tax): Anything beyond the cash surrender value of the policy is subject to capital gains tax. In a scenario where your settlement is $100,000 with a cash surrender value of $80,000, the additional $20,000 is subject to capital gains tax.

Although this tax structure simplifies the process, it provides clear guidelines.

- Proceeds up to your tax basis are not taxable.

- Proceeds exceeding the tax basis but within the cash surrender value are taxed as ordinary income.

- Proceeds beyond the cash surrender value are subject to capital gains tax.

Chapter 3: State-level taxation

The taxation of capital gains varies by state. Some states - such as Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming - do not impose ordinary income or capital gains tax, providing a tax advantage.

An additional nine states - including Arizona, Arkansas, Hawaii, Montana, New Mexico, North Dakota, South Carolina, Vermont and Wisconsin - offer preferential tax treatment for capital gains.

For residents outside these states, it's important to anticipate heavier taxation and seek professional tax advice tailored to your state.

Chapter 4: Timing is key.

Knowing when to consider a life insurance settlement is crucial. Some common scenarios include:

- Policies initially intended to protect a spouse who has died or a spouse who since has been divorced.

- Policies purchased for business purposes that are no longer relevant.

- Policies with beneficiaries who are no longer available or policies that are no longer needed.

- Policies with increasingly burdensome premium payments.

Chapter 5: Estate Tax Considerations

Many seniors acquired life insurance policies as a safeguard against estate taxes. However, with the significant increase in federal estate tax thresholds in 2024 ($13.61 million for individuals, $27.22 million for couples), these policies may no longer serve their intended purpose. This shift makes life settlements an attractive option for those whose estates fall below these thresholds.

Chapter 6: Looking ahead.

As we consider the landscape of life insurance settlements and taxation in 2024, it's essential to acknowledge the evolving tax environment. If your original plan was to allow the policy to lapse, a life settlement can offer financial benefits that would otherwise be forfeited. Although taxation is a factor, it represents a favorable outcome compared to receiving nothing or only the cash surrender value.

In navigating the complexities of life insurance settlements and taxation, remember that seeking advice from a tax professional is crucial. Each situation is unique, and professional guidance ensures compliance with tax regulations and helps you make informed decisions in this intricate financial realm.

Wm Scott Page, is a life insurance policy appraisal expert, published author and CEO at policyappraisal.com and WeBuy75.com. He may be contacted at [email protected].