Life Settlement Taxation
Doing some research on life settlement taxation is an important step when considering a life settlement. After all, the death benefit of a life insurance policy is well known to be a tax free benefit, however entering the policy into an investment contract does change things, but most of the time it is not likely to trigger a taxable event. Read on.
First and foremost, Life Settlement Option is not a legal tax advisor, but rather a broker solution to help clients get the highest offer in the marketplace for their policy. We can help provide a free appraisal and even test the market for you at no cost. And if you already have an offer we can also shop that offer around to see if we can get you something better from another investor. If we don’t, then you can feel confident proceeding with the offer you already have. It is always recommended to get more than one offer to ensure you’re getting a good deal. The best way to get in touch is either to fill out the Free Appraisal Form on this page or schedule a phone appointment with our broker by clicking on the button below. Learn how to afford a vacation home by giving me a call or filling out the form on this page.
In regards to Life Settlement Taxation, I must disclose that I am not a certified legal tax advisor and I am not authorized to provide legal tax advice. I have found, however, that many CPAs are unaware of recent improvements in tax laws around life settlements, and may be taxing them incorrectly based on an outdated law that changed with the Tax Cuts and Job Act of 2017 (TCJA). So with all that being said, part of obtaining a life settlement broker license includes some basic education around life settlement taxation, and with my experience in the marketplace I will share information I have learned from reviewing IRS documents and life settlement providers to help point you and your CPA in the right direction. This shall be considered my interpretation and not fact. You must seek legal tax council to file your taxes.
Now that we’ve disclosed that I’m not providing legal tax advice, if you want to cut to the chase, the modern tax rules made by the TCJA are that the premiums paid into the policy are your cost basis, or tax basis. Anything made beyond that in a settlement is considered taxable. If the surrender value exceeds your cost basis, then that amount of profit is considered regular income, and what is profit beyond the surrender value is considered capital gains. There are three tiers in which to consider whether you owe any taxes on your life settlement:
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Your cost basis is the premiums paid on the policy. If your settlement amount is less than your cost basis, you did not profit from this investment contract and do not owe taxes
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If your settlement amount exceeds your cost basis, then the excess amount is considered profit and taxed as regular income up to the surrender value
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If your settlement amount exceeds your cost basis and your surrender value, then that remaining amount of profit is considered capital gains
When an insured party can no longer afford their insurance policy, they can sell it for a certain amount of cash to an investor—usually an institutional investor. The cash payment is primarily tax-free for most policy owners. The insured person essentially transfers ownership of the policy to the investor. As we noted above, the insured party receives a cash payment in exchange for the policy—more than the surrender value, but less than the policy's prescribed payout at death. (1)
Here’s an example:
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A policy is sold for $100k. Premiums paid were $120k. The surrender value was $10k.
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This settlement’s cost basis was greater than the cash payout, and therefore the owner did not profit from this transaction and does not owe taxes
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A policy is sold for $100k. Premiums paid were $80k. The surrender value was $90k.
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This settlement turned a profit of $20k. Because the surrender value was also above the cost basis, $10k of profit is considered regular income, and the remaining $10k is considered capital gains
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A policy is sold for $100k. The premiums paid were $80k. The surrender value was $10k.
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This settlement turned a profit of $20k. Because the surrender value was less than the cost basis, then all $20k is considered capital gains
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Additionally, my interpretation of the latest IRS Revenue Ruling 2020-05, Situation 3 under Holdings Section #2, is that if your cost basis exceeds your settlement amount, you may be able to claim it as a loss.
As an example:
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A life insurance policy is sold for $100k. The premiums paid were $120k. The surrender value is $0.
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Because the cost basis is $20k more than the settlement, the seller of the policy may be able to claim $20k as a loss.
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When you accept a life settlement, you will receive a 1099 from the investor that purchased the policy, not from the broker. When sellers bring this 1099 to do their taxes, many CPAs end up reviewing the 2009-13 IRS ruling that created different scenarios for life settlements, which is an outdated ruling. In this ruling, the profit from a policy surrender was always considered regular income, but the article went on to create specific rules for life settlements that subtracted the cost of insurance from the cost basis, creating an unfavorable tax scenario in many situations while others couldn’t even retrieve the cost of insurance amount from the carrier making it an impractical accounting issue.
Additionally, term policies that were sold created very unfavorable taxes as they carried no surrender value. Long story short, the article published in 2009 over complicated the tax laws for seniors and caused many to lapse their policy instead of taking a settlement in fear of owing a lot of taxes.
The TCJA came into effect in 2018 and dramatically simplified tax laws in favor of the consumer, and decided that selling a policy and surrendering one should be treated similarly. When CPAs discover the 2009-13 ruling and not the updates, they’re unfortunately having their clients pay unnecessary taxes. If this has occurred to you, the ruling is retroactive to 2009 and should be considered and corrected.
Here's the original ruling from 2009: https://www.irs.gov/irb/2009-21_IRB#RR-2009-13
Here's an updated ruling that explains the original ruling with modifications updated:
https://www.irs.gov/pub/irs-drop/rr-20-05.pdf
Here's an article explaining the TCJA updates:
https://www.thinkadvisor.com/2018/01/03/new-tax-law-enhances-life-settlements-market/
Life Settlement Taxation Guide
Before I continue, I want to call out that life settlements where the insured is considered to have a terminal diagnosis or chronic illness is considered a viatical settlement, and is a non-taxable event. For everyone else, keep reading.
Following the TCJA, in order to figure out if you owe any taxes you need to establish your cost basis and subtract that from the settlement amount. Your cost basis is how much you’ve paid into the policy to date in premiums, thus making it much more simple for consumers to calculate.
As another example, let’s say you own a $500k life insurance policy and you’ve paid $150k in premiums over the years. You receive a life settlement for $100k. Because you’ve paid more money into the policy than you’re getting out of the investment contract, technically you have not gained anything in this investment. Because you have not gained a profit from this investment contract, then you should not owe any taxes on it.
If we keep a similar scenario of a $500k policy with $150k in premiums paid, and it has a $170k surrender value; they receive a $200k settlement. Right off the bat we know that $50k is considered profit and will be taxable. Because the surrender value is $20k above their cost basis, it will be taxed as regular income while the remaining $30k will be taxed as capital gains. All in? The profit on this settlement above the surrender value outweighs the taxes owed on it.
In my opening paragraph, I mentioned that most folks are not likely to owe taxes on their life settlement proceeds, and this is because in most cases people are not likely to get more in their settlement than they’ve paid into the policy. Life insurance is not intended to be a get-rich-quick scenario, so when an investor is taking over an existing policy it’s not going to be very profitable if they’re paying more than what’s been paid in premiums thus far unless the insured’s health has declined significantly and their life expectancy has been shortened since they applied for the life insurance way back when. To understand further, read on.
Staying with the same example, it’s not unusual for someone who owns a $500k universal life policy for a long time to have paid $150k in premiums or maybe even $200k. If someone is in their mid 70s and managing some health issues but otherwise getting along fine, the underwriter may give them an 8 - 10 year life expectancy, in which case they may receive offers in the range of $50k - $80k. These numbers are based on the cost of future premiums and the time value of money, not necessarily how much they’ve paid in premiums to keep the policy in-force over however many years.
It is possible that the insured may not be doing so well, or simply based on age the underwriter gives them a 3 - 5 year life expectancy. With a $500k policy it’s certainly possible for them to get $250k or even $300k in a settlement, so yes, in that case they are profiting from the settlement, and may owe taxes on that profit if their settlement is not considered a viatical.
In another case, someone takes out a $500k policy in their late 60s as they were in decent health when they applied, however in their early 70s their health has declined significantly. Perhaps in this case they’ve only paid $80k in premiums and are able to get a $200k settlement. If there’s no surrender value, then $120k is considered profit and taxed as capital gains. In this scenario, the owner of the policy will have to decide if they want to keep paying expensive premiums for possibly 5 plus more years, or accept the settlement despite owing some taxes. The difference in quality of life it provides may be worth every penny of tax owed for the profit gained.
When you consider these numbers, it’s only in rare situations where the seller of a policy is profiting significantly in a life settlement. When they are profiting significantly it’s usually when they’re considered terminal, making it a non-taxable event anyway. So you might even walk away with a six figure settlement and not owe any taxes. And if you do, well, chances are you may only need to claim a small amount out of the entire settlement.
How much you’ll be offered depends on your life expectancy, the face amount of your policy and how much the buyer expects to pay in premiums while you’re alive. Some of the money from a life settlement may be taxed as income or capital gains. (2)
Life Settlement Taxes Explained
Here are some examples of cases I’ve personally worked on to give you a better understanding.
A 71 yr old woman had a $500k term policy that was about to end. We were able to convert the policy to a universal life policy, and sell the conversion to an investor for $12k. They had paid roughly $35k in premiums over the life of the contract, and therefore technically did not profit from it. While this doesn’t affect taxation, the future premiums on the conversion policy were $24k a year, so they were happy to sell the policy instead of keeping it themselves.
A 95 year old man with a $950k universal life policy had paid $630k in premiums over the years. He received a settlement of $570k, so he did not owe any taxes. Again, while not relevant to life settlement taxation, the premiums on this policy were now $50k a year, so he was happy to sell it.
An 81 year old woman had a $3MM universal life policy and had paid $450k in premiums over the years. She received a life settlement for $305k, and did not owe any taxes. While not applicable to taxes, the premiums were $140k a year at that point, and she was happy to get a good portion of her investment back.
A 64 yr old woman with stage 4 cancer had a $200k universal life policy. She had paid about $50k in premiums and received a $140k settlement, but because she was considered terminal, the settlement was considered a non-taxable event.
While we’re playing around with numbers, part of my job as a life settlement broker is to help policy owners interpret the offers they receive from investors. When we were talking about life settlement taxation, we used an example of the $500k universal life policy, so let’s stay with that number for the purpose of interpreting a settlement offer.
Let’s say you have a $500k universal life policy, you’re in your mid to late 70s, and have a few health concerns you’re managing, but otherwise getting along. Perhaps the underwriter believes you’re likely to live another 10 years. Right now if you paid level premiums on your policy it might cost $25k a year to keep the policy in force.
When investors review a life settlement case they’re not trying to get rich off of you, but rather calculate a reasonable return on investment that’s in line with most other investments such as the stock market. Long term, the stock market has been known to provide around a 8% - 10% rate of return on a diversified portfolio. Because life settlement investments are a non-correlated investment or alternative investment, meaning not tied to market performance, many investment funds need diversification on their investments. As such, they will invest in life settlements, and life settlement investors should be delivering a similar level of performance as the market if they are to be considered good investments. They are not positioned to double, triple, or quadruple investments in a short period of time, so it’s important to keep this perspective when comparing your settlement amount versus your death benefit amount. I digress.
Getting back to the review of a case, if an investor sees a $25k annual premium and life expectancy of 10 years, right away they know this policy is likely going to cost $250k to keep it in-force. They also need to factor in the cost of the settlement payment and solve for an annual interest rate between 8% and 12%. Perhaps in this situation they offer $50k, which may seem like a lot less than $500k. Let’s take a closer look.
If the investor purchases the policy and pays premiums for another 10 years, they will have paid $300k into the policy and tied up capital for 10 years. They earn a $200k profit on the back end, but when calculated over a 10 year period, their return on investment solves to around a 10% annual interest rate, and it’s entirely possible the insured could live longer than 10 years, shrinking their margins every time they make a premium payment.
If you keep the policy, not taking into account your premiums paid to date, but just looking forward because now is when you have the power to change things, in a 10 year period you could double your money, which is not bad. There are other investments that will likely outperform that, but if you feel pretty confident that you have 10 years left, that’s a reasonable bet. And when you do factor in premiums paid thus far, the profitability on this investment actually shrinks quite a bit. Let’s look at how selling it looks too.
If you sell the policy, not only will you have $50k more in your savings account right now, but because you won’t be making that premium payment of $25k this year, your savings account will actually have $75k more in it this year than if you would have kept the policy and paid the $25k premium. Add in next year's premiums, and all the others for 10 years, and you actually will have $300k more in your savings than you would have if you had kept the policy. Suddenly that $50k had a much bigger impact on your cash flow than its initial amount.
When we make a payment towards an asset such as a home mortgage or vehicle, we are enjoying that asset as we pay for it. Life insurance is different in that you keep making payments with no material benefit until your passing, and there’s no telling how long you’ll be making those payments.
If you need the coverage and can afford it, by all means keep the policy. But if the premiums are making your budget tight and tying up capital that could work better for you in other ways, maybe that $50k offer is the way to go.
Proceeds from a life settlement can be used however you wish. Perhaps it helps to supplement your retirement income, making things a little easier to live comfortably. Others may use that $50k to invest elsewhere.
Many families long for a vacation home, and perhaps this gives you your chance to make a down payment on a cabin, beach house, or luxury condo. Choose your vacation home wisely, and turn it into an income stream, renting it out while you’re not using it. In this scenario perhaps you’re breaking even on your mortgage and upkeep, or maybe even turning a profit, further supplementing your retirement. And instead of a death benefit, you’ll be leaving your family with an asset that may eventually be worth more than the $500k death benefit on your life insurance policy. In my opinion this is a win for everyone.
One client of mine joked that they were going to throw their settlement into Bitcoin in hopes of increasing their money significantly and rapidly. At least I think it was a joke, but you’re free to go in on a high risk investment if you wish. I don’t know that I would recommend it with this money however, but that is your choice.
And lastly, perhaps you prefer the idea of distributing wealth while you’re still alive. Give that money to your kids so that they may use it to buy a vacation home, or make a down payment on their own home. You can leave a legacy while you’re still here. Here are more pros and cons of selling life insurance policy if you are interested in that route.
Hopefully this gives you an idea of how life settlements are taxed, and gives you more confidence to test the marketplace. We’ve had a strong track record of helping clients sell their policy, and hope we can help you too.
Keep in mind, what you've read here is an interpretation of the IRS rulings for life settlements. You must consult with a legal tax advisor to make a determination on if and how much your settlement will be taxed.
Zack Taylor
4 years in life settlements