The sale of a life insurance policy can be a taxable event. We provide a general explanation of the process here, but you should seek advice from you tax advisor to help with your specific situation.
To illustrate the tax treatment, let's examine an example. Here is a summary of the facts provided by the example:
Cash surrender value of $78,000
Total premiums paid of $64,000
The policy is sold for $80,000 in a life settlement transaction
The individual is not terminally or chronically ill
The policy has been owned for 8 years, has had no withdrawals, and has had no loans
In the example, the taxable amount is the proceeds minus the premiums paid. In this example:
Life Settlement Proceeds: $80,000
Paid Premiums: $64,000
Gains (taxable income): $16,000
Of the taxable income, the portion that is the policy's internal "profit" (surrender value less premiums paid) is taxed as ordinary income. The remaining is treated as a gain on property interest and is taxed at capital gains rate. In this example, the internal "profit" is $78,000 - $64,000 = $14,000.
Therefore $14,000 is taxed as ordinary income, and $2,000 is taxed as long term capital gains.
The example above includes new revised rulings from the Tax Cuts and Jobs Act of 2017. Visit our blog to see a comparison of how life settlements are taxed pre and post TCJA.
To determine whether it would be better from an economic standpoint for the policy owner to sell or surrender the life insurance policy, the net proceeds that remain from a life settlement after taxes must be compared to the after-tax proceeds an individual would obtain from surrendering the policy.
Again this example only covers the basics of how taxation for life settlements work. You should contact a tax advisor for advice when evaluating your specific case. A good place to start is to see how much your policy could be worth.