Understanding the Tax Rules for Life Settlement Proceeds in 2023

Tax season is fast approaching, which is why it’s essential to understand how the proceeds of a life settlement are taxed. Not all life settlements are the same, as the amount of tax you will need to pay on a settlement can vary significantly for many reasons. Reaching out to a tax expert or an experienced accountant is always a good idea to better understand the tax implications of a life settlement.

Here are a few things to consider for a life settlement:

Don’t Let a Policy Lapse

One common mistake is letting a policy lapse, which forfeits all your benefits, and you won’t get back any of your premiums. Paying higher taxes on your life settlement is better than not receiving anything in return. The payment from a life settlement about to expire can be considered “found money,” as these funds wouldn’t even be available without a settlement. Paying taxes on found money is always better than not getting anything back on your life settlement.

Health Status Impacts Taxation on Life Settlement

One of the most significant factors affecting the taxation of a life settlement is the health of the person insured. For example, the life settlement proceeds are tax-free for someone considered terminally ill, meaning their life expectancy is less than two years. This transaction is also known as a viatical settlement, and the tax implications are much different compared to a traditional life settlement.

According to the IRS, a terminally ill person is anyone certified by a doctor as having a physical condition or illness that can be expected to lead to death in two years or less after the certification date.

Additionally, the settlement proceeds of someone chronically ill aren’t subject to taxes.

The IRS considers an individual chronically ill if they have been certified by a health care practitioner as unable to perform at least two everyday living activities for at least 90 days without significant assistance because of a loss of functional capacity. Examples of daily living activities include eating, dressing, getting in and out of bed, taking a bath, and using the toilet. Someone can also be considered chronically ill if they require considerable supervision to protect their health because of severe cognitive impairment.

You won’t have to worry about taxing the proceeds of a life settlement if the insured is chronically or terminally ill by IRS standards.

Why Traditional Life Settlements Are More Complicated

The tax process for a traditional life settlement is much more complex, as it includes three tiers of taxation.

The first tier is considered tax-free, meaning any proceeds from the settlement up to your tax basis aren’t taxable. This also includes the premiums you paid into your policy. For example, if a life settlement is $100,000, and your tax basis is $50,000, you wouldn’t pay any taxes on the first $50,000, but you will pay taxes on the remaining $50,000.

The second tier is classified and taxed as ordinary income. The proceeds higher than your tax basis and even up to the cash surrender value are taxed as regular income. Anything higher is in the third tier, taxed as a capital gain. For example, $50,000 is tax-free if your basis is $50,000 on a $100,000 cash settlement. You will also need to pay ordinary income tax on the $30,000 and capital gains tax on the remaining $20,000 if the cash surrender value is $80,000.

Here is a general overview of this process:

• Sale proceeds aren’t taxable up to the amount of the cost basis.

• Sale proceeds are taxed as ordinary income if they are higher than the cost basis and up to the cash surrender value.

• Any remaining sales proceeds are taxed as a long-term capital gain.

How Are Estate Taxes Handled?

Understanding estate taxes are also important with life insurance policies. A life insurance policy was often bought to help pay for estate taxes. Recently, changes were made to increase the estate tax exemptions, as it’s now $12.92 million for individuals and $25.84 million for married couples. However, many people bought policies before the exemption was changed. Suppose you purchased a policy five years ago to pay future estate taxes. In that case, the policy might not be needed due to the higher exemption, which is a great reason to sell your policy on the secondary market.

When Should You Get an Appraisal?

Tax advisors can help clients determine if a life insurance settlement is the right decision with a policy appraisal. Any policies that fit in these categories are great candidates for obtaining an appraisal:

• A policy is no longer needed, or if the beneficiary has passed away

• Bought a policy to fund a buy/sell agreement for a company that no longer exists

• Policy becomes too expensive with ever-increasing premiums

• An executive leaves a company, and a key person policy is no longer needed

Closing Thoughts

Working with a tax advisor is always recommended if you need a policy appraisal. These professionals can help you understand the value of a life settlement while discussing your options. A tax advisor can also determine how taxes will impact the overall value of your life insurance settlement to ensure you make the right decision for your situation.

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