Depending on specific financial and estate planning circumstances, sometimes selling your life insurance policy makes the most sense. Life insurance also comes with favorable taxation on “Life Settlements”.

A life settlement is where the policy owner sells the contract to a third party. But do you know how life settlement proceeds are taxed?

Understanding how life settlement taxation works can help you and your clients determine better if a life settlement is the right choice.

How Life Settlement Taxation Works:

1.  Sales proceeds up to the amount of the cost basis are tax free.
2. Sales proceeds above the cost basis and up to the policy’s surrender value are taxed as ordinary income.
3. Any remaining sale proceeds above the surrender value are only taxed as long-term capital gains.

Life Settlement Case Example:

• Policy Type: $1,000,000 UL
• Premiums: $70,000 (Cost Basis)
• Cash Value: $80,000 (Surrender Value)

Case Example Tax Breakdown:

• Policy Sale Price: $300,000 (Settlement Amount Paid to Policy Owner)
• Tax Free: $70,000 (Cost Basis/Amount Paid in Premiums)
• Taxed as Ordinary Income: $10,000 (Sale Proceeds Above Cost Basis and up to Surrender Value)
• Taxed as Long-Term Capital Gains: $220,000 (Remaining Sale Proceeds)

• Tax Cuts and Jobs Act of 2017 (TCJA)

 

EXAMPLES: CASE STUDIES

Business Expansion:

a 78 year old entrepreneur, and primary shareholder of a closely held family business finally gets around to developing his Estate Plan. Son and daughter-in-law have been in the business for 20 years, but are only now the heir apparent. The 78 year old suffers a few TIAs, forcing the issue of the business transition. He owns a life insurance policy worth $1,000,000 with cash value of approximately $73,000. He sells the policy for approximately

$310,000. The proceeds make the purchase of the business more palatable for the son and daughter-in-law to afford the business and the 78 year old now has the liquidity he didn’t have to sustain a long-term care stay in senior housing. So what started out as a business transition consult, turned into a succession plan for a child and a long term care plan. Without the knowledge of ‘LIFE SETTLEMENTS’ this family wouldn’t have been able to do either.

Policy Rescue:

a 75 year old female purchased a term policy 10 years ago when she refinanced her home and took cash out. She spends her deceased husband’s estate, having retired early from the school system and quickly realizes with too much free time that she spends a great portion of her time shopping. Reality sets in and before you know it, she becomes worried about what the future has in store for her. Seeing her friends diagnosed with this, that, and the other, she gets referred to us for a budget and to see whether or not her assets can survive her or not. We evaluate her Term Policy of $500,000 which she no longer needs since she is upside down in her home anyway. Term is not usually considered an asset since it has no cash value and because it terminates most often without paying out as a death claim. In this case, the policy is conversionable for more money. We find a buyer for the policy and convert the term to permanent with a new premium. This allows the acquirer to have certainty on a future return on investment, and she receives $117,000 giving her the ability to sustain herself long enough to help her grow her other nest eggs so she can afford the future and whatever it may bring.