Are Life Settlements Taxable?

A life settlement involves the sale of an existing life insurance policy to a third party for a cash sum. This amount typically exceeds the policy’s cash surrender value but remains less than its death benefit. For many individuals, this transaction provides a way to access liquidity from an asset that may no longer align with their financial planning. Proceeds from a life settlement are generally considered taxable events. This article clarifies the tax implications associated with these transactions.

Understanding Policy Basis and Proceeds

To determine the tax implications of a life settlement, it is necessary to understand several key financial components. Premiums paid represent the total amount the policyholder has contributed to the policy, forming the foundation for calculating the policy’s cost basis.

The cost basis is the policyholder’s investment in the policy for tax purposes. It is generally calculated as the total premiums paid, reduced by any amounts previously received tax-free, such as dividends used to lower premiums.

The cash surrender value (CSV) is the amount the insurance company would pay the policyholder if the policy were terminated before its maturity or the insured’s death. Gross proceeds refer to the total cash amount the policyholder receives from the life settlement company, which is the lump sum paid by the third-party buyer for ownership of the policy.

Federal Income Tax Rules

A life settlement transaction is typically treated by the Internal Revenue Service (IRS) as the sale of property for federal income tax purposes. The Tax Cuts and Jobs Act of 2017 (TCJA) established a three-tiered approach to taxing the proceeds. This framework helps determine how much of the settlement amount is subject to tax and at what rate.

The first portion of the gross proceeds is considered a return of the policyholder’s cost basis. This amount, representing the policyholder’s original investment, is generally received tax-free. For example, if a policyholder paid $30,000 in premiums and the settlement proceeds are $75,000, the initial $30,000 is not subject to tax.

Any proceeds exceeding the cost basis but not exceeding the policy’s cash surrender value are generally taxed as ordinary income. This effectively treats the “inside build-up” of the policy’s cash value as taxable income, similar to interest earned in a savings account. For instance, if the cost basis was $30,000 and the cash surrender value was $35,000, the $5,000 difference would be taxed at ordinary income rates.

The third component covers any proceeds that exceed both the cost basis and the cash surrender value. This final portion of the gain is typically taxed as a capital gain. Whether it is a short-term or long-term capital gain depends on how long the policy was held before the sale. The applicable tax rates for ordinary income and capital gains depend on the individual taxpayer’s overall income bracket.

Reporting Requirements and State Taxes

Individuals who complete a life settlement transaction will receive Form 1099-LS, “Reportable Life Insurance Sale,” from the life settlement provider. This form is issued to the policyholder and the IRS, providing details about the transaction, including gross proceeds and, in some cases, the policy’s cost basis.

The information from Form 1099-LS is used when preparing the federal income tax return. The portion of the gain taxed as ordinary income is typically reported on Form 1040, while the capital gain portion is reported on Schedule D and potentially Form 8949. Accurate reporting ensures compliance with federal tax regulations.

Beyond federal taxes, life settlement proceeds may also be subject to state income taxes. State tax laws vary significantly across the United States. Policyholders should consult their specific state’s tax regulations or seek advice from a qualified tax professional to understand any state-specific tax obligations.