A Basic Overview of Life Settlement Taxation

For some of your high net worth clients, the financial strategy of liquidating life insurance through a life settlement comes with tax implications.

The taxation of life settlements is governed by the Tax Cuts and Jobs Act of 2017 (TCJA), signed into law by former President Trump in early 2018. The TCJA created a more favorable tax structure for insured by simplifying the definition of the cost base.

Today, the cost base of a life insurance settlement is the cumulative premiums paid on the policy sold. Prior to the TCJA, the cost basis was the total premiums paid less the cost of insurance (COI). This was problematic for two reasons:

  1. COI was often not available to policyholders
  2. Reduced premiums per COI resulted in a lower cost base

Since proceeds up to the policyholder’s cost basis are not taxable, the lower cost basis has triggered a greater tax burden for selling policyholders.

The settlement proceeds for life above cost base are taxable at two levels:

  1. Proceeds in excess of the cost and up to the cash surrender value of the policy are taxed as ordinary income.
  2. Proceeds in excess of the policy’s cash value are taxed as long-term capital gains.

Consider a policy that sells for $110,000. If the policyholder paid $50,000 in cumulative premiums, the total taxable gain is $60,000. Assuming a cash surrender value of $55,000, $5,000 of the $60,000 gain is taxable at the policyholder’s income tax rate. The IRS treats the rest of the gain as a long-term capital gain.

State taxation of life settlements

Seller insureds may also be liable for state taxes in their home state. The tax treatment of life settlements in each state aligns with the state’s general approach to taxing income and capital gains. There are three scenarios:

  1. In states that do not collect taxes on income or investment gains, policyholders will pay federal taxes only on the proceeds of the life settlement.
  2. In states that do not offer lower capital gains rates, the policyholder’s state income tax rate will apply to the entire taxable gain, or net proceeds less cumulative bonuses.
  3. In states that have their own capital gains rules, policyholders would first calculate the two levels of gains, as dictated by the TCJA. The state income rate would apply to the income portion of the proceeds, and the state’s normal capital gains rules would apply to the remainder.

After-tax proceeds exceed cash surrender value

Regardless of where the policyholder resides, the after-tax proceeds from a life settlement will exceed the proceeds generated from surrendering the life insurance policy. Using the numbers from the example above, the policyholder can either redeem this policy for $55,000 or sell it for $110,000.

After broker commissions, federal taxes, and state taxes, the net cash sale proceeds of $110,000 will still be greater than the cash redemption value of $55,000. Of course, this does not assume any major changes to the tax code that applies to life settlements or to income and capital gains tax rates.

While the Biden administration has proposed major tax rate increases for high-income earners in the 2021 plan for American families, there has not been enough congressional support for this to date. effort. For now, policyholders can view the life settlement as a strategy to maximize the value of their life insurance. Although the gain on the transaction is taxable, the net proceeds will exceed the cash value of the policy.

An experienced tax professional can assess how the additional gain will affect the policyholder’s overall tax burden for the year.