Insurance agents and financial advisors fill many roles for their clients. Of course, they offer financial advice, but they also are asked about accounting and tax questions. Sometimes they also act as business coaches and even amateur psychologists. As we enter the new year, the economic situation for many will get tougher, and clients will have many questions for their advisors. It will be particularly challenging for folks on fixed incomes and small business owners. Things will probably get worse before they get better.
Some clients will be good candidates for life insurance settlements as they offer a chance for seniors to convert a life insurance policy into cash. We are often asked about life insurance settlements and how they fit into long-term planning strategies.
A life settlement can turn a non-performing asset into funds that can be used to cover living expenses and used to make someone's financial life a little bit better. Agents and advisors should be prepared to explain how life settlements work and the pros and cons. They need to be a confidante for clients but also the expert. And the taxation question will certainly come up very early in the conversation.
How life insurance settlements are taxed is a complicated question, and we recommend that agents always run the scenario by a tax expert before finalizing a transaction.
The first thing to know is that there are no simple, sweeping answers when it comes to taxes and life settlements. Life insurance companies will say that an insurance settlement should not be performed because of tax consequences – this is flat wrong. Every life settlement beats the cash surrender value of a policy, even after taxes, so steer clear of insurance companies that attempt to convince you otherwise.
The key question: How much of the settlement will be taxed and at what rate?
Before we can start to answer, we first should understand the client’s life expectancy. If an agent is discussing an insurance settlement with an unhealthy individual or someone with a terminal illness, then the life settlement proceeds may be tax-free. A person with a life expectancy of fewer than two years is eligible for what is known as a viatical settlement. This could provide a significant and tax-free payout for a client, but the only way to determine the life expectancy is to have the policy appraised and the client’s situation analyzed by an expert. This is precisely what we do at PolicyAppraisal.com. So, the very first step is to perform an appraisal to see if further analysis is necessary for a possible tax-free settlement.
For a more typical life settlement, when a client has a life expectancy of more than two years, the tax equation is a bit more complicated. Simple explanation: The amount of a life settlement that's considered profit – which is the difference between the premiums paid into the policy and the cash payout that is received – is taxable. Some of the profit is taxed as ordinary income, and some of it is taxed as capital gains. As advisors know, for many clients, there's a big difference between the tax rates for ordinary income and capital gains.
Here are some additional details:
1) The client’s tax basis must be determined.
2) The settlement amount received up to the tax basis is not taxed.
3) The amount received in excess of the tax basis, but up to the cash surrender value, is taxed as ordinary income.
4) The amount received in excess of the cash surrender value is taxed at the capital gains rate.
As mentioned earlier, we always recommend consulting a tax expert to be certain about tax consequences, particularly before a transaction is finalized. We know that the calculation is complicated but it is absolutely something that agents can compute on behalf of their clients. However, there is no way of making an intelligent assessment without first having an appraisal.
A life insurance policy appraisal not only offers a glimpse at life expectancy, which can have a dramatic impact on taxation, but it also offers the best analysis of a settlement payout for a client.