A typical life insurance death benefit is well known to be a tax - free benefit, however, things get a little different when you are selling your existing life insurance policy to a 3rd party investor in a life settlement.
While the word “Taxes” can make many shrivel up and cancel any aspirations they had for a life settlement, fear not! There’s a good chance you may not owe any taxes on your settlement.
Before we take a close look, I must disclose that I am not a legal tax advisor, but rather a licensed life settlement broker. With that said, part of obtaining my license includes having a basic understanding of how life settlements are taxed.
You might be thinking - hey, if a death benefit is tax-free, then why should I have to pay any taxes on a reduced benefit?
Well, because life insurance is indeed insurance, and because you haven’t died to receive this benefit, selling your policy looks more like an investment contract in the eyes of the IRS. As such, when you’re selling your policy to an investor the IRS has simplified how they review life settlements making it fairly easy to figure out. They’re looking at how much money you paid in premiums on the policy versus how much you’re getting from the settlement company.
The amount you’ve paid in premiums is considered your tax basis, and if your settlement amount exceeds your tax basis then the difference is considered profit and taxed as long term capital gains. There are two exceptions to this ruling:
When the cash value exceeds the premiums paid on the policy, the amount from the premiums paid up to the cash surrender value is considered regular income, and the difference between the cash surrender value and the settlement is then considered long term capital gains.
When an insured is terminally ill having 24 months or less to live, the settlement is non-taxable. The insured must obtain a letter from their doctor stating their life expectancy to support the 1099-LTC that is issued for these types of viatical settlements
When the beneficiary of a life insurance policy receives a death benefit, this money is not counted as taxable gross income. However, situations do exist where the beneficiary is taxed on some or all of a policy's proceeds. (1)
As an example, It’s not unusual for someone to sell a term life insurance policy where they’ve paid $40k in premiums over the life of the policy. And because they’re in their early 70s and likely have another 15 - 20 years left to live, their settlement amount might be around $20k. Because the owner of this policy paid more in premiums than they received for a settlement they do not owe any taxes on the $20k settlement.
In another case, someone with a $1MM universal life insurance policy had paid $400k in premiums since the policy started, and received a settlement for $350k. Again, despite receiving a six figure life settlement, they do not owe any taxes on it because their tax basis of $400k exceeded their settlement amount.
Going along with this theme, the truth is that it’s rare that a life settlement exceeds the amount in which someone has paid in premiums on a policy unless there is some sort of terminal illness involved. Life insurance is not intended to be a highly profitable situation unless there is an early and unexpected death. But this is not all bad news. In the example we just did, the owner of the policy had 12 years of life insurance coverage and was now in their early 80s. Not everyone lives that long, so having that coverage was good for them to have. And because their annual premium was $30k, the difference between the $400k she paid and the $350k she received from the settlement, when you look at this big picture she basically paid $50k which was less than 2 years of coverage out of the 12 years that she had it, and got almost all of her money back. Now she has the freedom of investing that money in something else where she has more control.
In another example someone has paid $400k in premiums and receives a settlement for $500k. The reason they’re able to exceed the premiums paid is largely due to the fact that they have an illness that only gives them another 8 years or so. Because the illness provides a strong predictability on the investment, they’re able to offer more. So in this case the seller exceed his tax basis by $100k and will owe $20k in capital gains taxes based on a 20% capital gains tax rate. $20k out of the $500k settlement is actually not so bad.
Let’s address those two exceptions to this simplified tax ruling:
You have a universal life policy where the owner has paid $300k in premiums, the cash surrender value is $350k, and the life settlement is $400k. While the seller technically profits $100k in this deal, they have $50k in cash surrender value exceeding their tax basis. The $50k gets treated as regular income, and the remaining $50k of profit gets treated as long term capital gains. In all reality, this situation is probably pretty rare, but that is the ruling when it comes up.
And lastly the terminal illness ruling - The owner of a policy has paid $30k in premiums and receives $250k in a life settlement because the insured has stage 4 cancer. Despite the fact that they have profited $220k on this investment contract, their terminal illness is enough of a challenge and the IRS considers their settlement non-taxable.
At this stage you might be thinking that it’s crazy to sell a life insurance policy when you know you only have a couple years left, and that may have a better return on investment for one person, but another might be struggling to make ends meet while they manage their terminal illness. They may not be able to work anymore, and may not be able to afford alternative treatments. By selling their policy they have the opportunity to not worry about bills or income, and can make the most of their final years.
Another big question is who buys life insurance policies?
The life settlement marketplace is a multi billion dollar industry, and there are many different investors that purchase policies to help diversify their investment portfolio. There are hedge fund companies, mutual fund companies, and even private investors that buy policies.
Someone looking to sell their policy might be looking for a list of companies that buy policies and try to sell their policy themselves. And while this is possible, most of these companies are not consumer facing, so the best way to get the most exposure in the marketplace is to work with a broker who has relationships with a wide range of investors and can help you find the highest offer. A great way to get a free consultation is by filling using out free appraisal request form, which you can find the button at the top of the page.
(1) References: https://www.investopedia.com/ask/answers/102015/do-beneficiaries-pay-taxes-life-insurance.asp
4 years in life settlements
About the author:
I'm a life settlement advocate who became passionate about the industry when I helped my grandfather secure over 60% of his death benefit. Recently, I assisted an 81-year-old woman with $140k annual premiums by finding an investor to buy out her policy while still receiving most of her investment back.
I've also helped clients with expiring term policies receive payouts of $10k - $15k by converting to a new universal life policy. I enjoy educating both agents and clients on the potential benefits of life settlements and am always happy to provide feedback on potential cases.