Will My Life Insurance Settlement be Taxed?
A life insurance settlement involves selling your life insurance policy to a third party. Typically, you sell the policy to a company in exchange for an immediate lump-sum cash payment.
In exchange, the life insurance buyer takes on paying remaining premiums and receives the policy’s death benefit when you die. To be eligible for this type of settlement, you usually must be 65 or older and have a valuable policy.
While life settlements offer an effective way to receive immediate cash, some of that cash will still be subjected to taxes.
This is important to consider when exploring a life settlement, and it can catch sellers off-guard. When a life insurance policy holder dies, the beneficiary usually receives the death benefit tax-free. So it’s easy to expect that receiving a payment for selling the policy would work in the same way. In reality, however, the lump sum that you receive is treated as income, not as a benefit.
Adding to the confusion is the fact that there are some types of life insurance sales that can result in a lump sum that isn’t taxed. For example, viatical settlements are a type of life settlement that involves a seller who is terminally ill and has less than two years to live. In a viatical settlement, the payment that the seller receives is typically not taxable.
How Are Life Insurance Settlements Taxed?
The way that life insurance settlements are taxed can be a bit confusing and can also vary from policy to policy.
Generally, you will not have to pay taxes on an amount that equals what you have paid into the policy in aggregate premium payments when you sell your policy. The part of your lump sum payment that will be taxed is the amount of money that exceeds what you’ve paid in premiums.
A simplified example would look something like this: You receive a lump sum payment of $50,000 on a policy that you have spent $30,000 on in premiums. The part that is subject to taxes then is the remaining $20,000.
Things get further complicated depending on whether or not your policy has a cash value. According to Forbes, if your policy does not have a cash surrender value, then you may face a capital gains tax. But if there is a cash value, then any proceeds beyond that value are treated as capital gains and proceeds beneath it are treated as standard income.
How the Tax Cuts and Jobs Act of 2017 Affects Life Insurance Settlement Taxation
The way that life insurance settlements are taxed went through a change with the Tax Cuts and Jobs Act of 2017.
Essentially, the act changed the rules surrounding life settlements so that they are taxed in largely the same way that surrendering a policy would be taxed.
Before the change, it was less advantageous from a tax perspective to sell your policy vs surrendering it.
This could create issues for sellers because it is typically more valuable to sell a policy than surrender it. Third parties hoping to buy policies do so by offering an amount that falls somewhere in between the surrender value and the death benefit.
Surrendered policies and sold policies being taxed similarly helps to allow simpler choices for beneficiaries.
Read More: Life Settlement FAQs
State Life Insurance Settlement Taxes
State income tax may factor into what you owe on a life settlement as well. Different states have their own tax rules, and you may be subject to additional taxes.
There are several states that do not have an income tax. If you live in one of those states, then you only have to worry about paying federal taxes on your payout from a life settlement.
States with No State Income Tax
- New Hampshire
- South Dakota
If you live in an area that does have a state income tax, then you may have to expect to pay more in taxes on the payment you receive from a life settlement.
It’s important to consider your specific circumstances, including something like a state tax, when deciding whether or not a life settlement makes sense for you.
The same life settlement deal may not make sense for every seller.
Life Insurance Settlement Tax Example
Remember that how settlements are taxed will vary in a few different ways. The type of policy you have and how much you have paid in premiums can play a role.
For one example, say that you have a life insurance policy with a death benefit of $500,000 and you sell the policy in a life settlement that nets you a lump sum payment of $150,000.
Let’s also say that over your life you have spent $50,000 on premiums of the policy and that there was a surrender value of $100,000.
You would not owe taxes on $50,000 of your payout since that is what you spent on premiums. Then $50,000 would be taxed as ordinary income since it is the amount between your cost basis and surrender value. The final $50,000 that exceeds the surrender value would be taxed as capital gain.
Consulting a Tax Professional About Life Insurance Settlements
If you are looking into potentially selling your life insurance policy in a life settlement, it may make sense to first speak to a tax professional.
How life settlements are taxed is a confusing area. There can be differences depending on the type of life insurance policy you hold, how much you have paid in premiums, whether there is a cash value and what state you are in.
It may be difficult to get a clear sense of the tax implications on your own.
Speaking with a tax professional can help you to better understand your options and also prevent you from making any serious mistakes or ending up in a life settlement that was not truly advantageous for you.
A tax professional may also be able to help you determine if a life settlement makes sense at all. If you are in need of cash, there are several other ways to get money from a policy that does not involve selling it to a third party.