Selling a life insurance policy through a life settlement can unlock significant financial value, but the transaction may also have tax implications. Many policyholders are unaware that the proceeds from a life settlement may be partially taxable, depending on factors such as the cost basis and surrender value. Understanding these tax considerations is the key to maximizing your payout and avoiding unpleasant surprises during tax season.
The following guide explains life settlement taxation, provides real-world examples and shares strategies for minimizing tax obligations. Whether you are considering a life settlement or are already in the process, we’ll provide the clarity you need to make informed decisions.
HOW A LIFE SETTLEMENT WORKS
A life settlement is a financial transaction in which the owner of a life insurance policy sells it to a third-party buyer for more than its cash surrender value but less than its death benefit. The buyer takes over the policy, becomes responsible for paying the future premiums and collects the death benefit upon the insured’s passing.
The proceeds from a life settlement may be subject to taxes based on the seller’s cost basis, the policy’s cash surrender value (CSV) and the final sale amount. It is important to consult a tax advisor to understand and plan for any potential tax obligations.
IS A LIFE INSURANCE SETTLEMENT TAXABLE?
Selling your life insurance policy is classified as a capital gain event, which means you may pay taxes on life insurance settlement proceeds. Whether and how much you owe depends on your policy’s cost basis, its cash surrender value and how much you have received in proceeds.
- Cost basis: This is the total amount of money you have put into your policy, including all the premiums you have paid. If the proceeds from your life settlement are equal to or less than this amount, they are generally not subject to taxes.
- Cash surrender value (CSV): This is the amount of money you can receive if you decide to cancel (surrender) your life insurance policy before it matures or you pass away. Proceeds exceeding the cost basis but below the policy’s CSV are treated as ordinary income and taxed accordingly.
- Capital gains: Any proceeds above the CSV are taxed as capital gains, which may result in a lower tax rate than ordinary income.
- Policy loans: If you have borrowed against your policy, any outstanding loan balance is deducted from the proceeds and may affect the taxable amount.
These rules provide the foundation for understanding how your life settlement will be taxed.
LIFE SETTLEMENT TAXATION IN ACTION
Let’s look at a few examples to clarify how taxes on life settlements work:
- Sale below cash surrender value: You sell a policy for $20,000, and your premiums total $25,000. In this case, the entire $20,000 is tax-free since it does not exceed your cost basis.
- Sale above cash surrender value: Your policy has a CSV of $50,000, and you sell it for $80,000. If your total premiums are $30,000:
- The first $30,000 is tax-free (return of cost basis).
- The next $20,000 (CSV minus cost basis) is taxed as ordinary income.
- The remaining $30,000 (proceeds above CSV) is taxed as a capital gain.
- Policy with loans: If your policy sells for $60,000 but has a $15,000 outstanding loan, the loan is deducted from the proceeds. In this case, you calculate your taxable income based on the reduced payout of $45,000.
State laws can also affect the taxes you owe. Some states have additional rules for life settlements, including how they are taxed and regulated. It is essential to check the laws in your area — or work with a professional who understands them — to avoid complications.
MINIMIZING YOUR TAX OBLIGATIONS IN A LIFE SETTLEMENT
While paying taxes on a life settlement may be unavoidable, there are ways to reduce the amount you owe:
- Consult a tax advisor: An experienced tax professional can analyze your policy and provide advice tailored to your situation.
- Offset gains with losses: If you have losses from other investments, you may be able to use them to offset your taxable gains from a life settlement.
- Monitor your premium payments: By keeping track of the premiums you have paid, you can confirm the tax-free portion of your settlement.
- Plan for low-income years: Selling your policy during a year when your income is lower can reduce your tax bracket and overall liability.
- Consider a trust: Placing your policy in a trust before selling may provide tax advantages, but this requires expert legal advice.
These strategies can help you retain more of your settlement proceeds and ensure compliance with federal and state tax laws.
HOW TO REPORT THE SALE OF AN INSURANCE POLICY
Once you have completed a life settlement, you must report the sale accurately to avoid any penalties or audits. Here is how to handle the paperwork:
- 1. Complete Form 1099-LS: The provider (buyer) must issue this form so you can report the transaction when filing your annual tax return.
- 2. Complete Form 1099-B: If applicable, complete this form to report the taxable portion of the transaction.
- 3. File your tax return: Work with a knowledgeable tax professional who will use the information from the forms above to calculate your final tax obligation. When filing your tax return, make sure you retain documentation of the premiums you paid and the cost basis calculation for your records.
STAY INFORMED ABOUT TAXES ON YOUR LIFE SETTLEMENT
A life settlement offers a unique financial opportunity but has tax implications that should not be overlooked. Understanding how taxes apply to the proceeds of a life settlement can help you make smarter financial decisions.
At Life Settlement Advisors, we help clients convert unwanted life insurance policies into cash through life settlements. Contact us today to explore how we can help you make informed decisions about your policy and maximize its value.
