The Tax Issues Those TV Ads Don't Tell You About Selling Your Life Insurance Policy

Article Highlights:

• Advertisements
• Life Settlements: What to Expect
• Disposition of a Policy: Surrender or Sale
• Tax Implications for Policyholders
• Viatical Settlements: A Specific Scenario
• Information Reporting
• Final Thoughts

When watching television, you've probably seen those advertisements promising quick cash for unneeded life insurance policies. These commercials often target those who might not see the need for policies anymore, offering substantial financial returns. While these transactions can indeed serve as a financial option, especially for those in need of immediate liquidity, the process of selling a life insurance policy—known as a life settlement—comes with a labyrinth of financial implications, particularly around taxes. Let’s explore the various facets involved with life settlements, from potential settlement amounts, tax issues related to policy disposition, and end with a look at viatical settlements for individuals with health concerns.

Life Settlements: What to Expect - A life settlement involves the sale of a life insurance policy to a third party for more than its cash surrender value but less than its net death benefit. The proceeds from a life settlement can offer policyholders much-needed liquidity for retirement, debt repayment, or other financial obligations.

• Reasons for Considering a Life Settlement - include:
  
  o   Funds are needed to pay medical or long-term care expenses,
  
  o   The insured can no longer afford the premiums,
  
  o   The primary beneficiary has died, and the policy is no longer needed,
  
  o   The insured got divorced,
  
  o   Business circumstances have changed, and the coverage is no longer needed to fund a buy-sell agreement, and
  
  o   Expected death tax costs have been reduced or eliminated and the coverage is no longer needed to pay death taxes.
  
  
• Potential Settlement Amounts - The amount you receive from a life settlement will depend on various factors, including your age, health condition, and the type and size of the policy. Some reports say that the average payout is 10%-35% of the face amount of the policy but they can vary widely. Generally, the older the policyholder or the poorer their health, the higher the settlement offer tends to be, as the buyer of the policy will receive the payout from the death benefit sooner. However, these transactions typically yield a payout that is significantly less than the death benefit of the policy but more than the surrender value.
   

Disposition of a Policy: Surrender or Sale - When it comes to disposing of a life insurance policy, policyholders have two primary options: surrendering the policy or selling it.

• Policy Surrender - Surrendering a policy means you’ll cancel the insurance and in exchange the insurance company will pay you the policy's cash value, net of any redemption fees specified in the contract. If there is no cash value, there is no payment to the policyholder. This option can be straightforward, especially with term policies that typically do not accumulate cash value. However, surrendering a policy could result in tax implications, particularly if your cash surrender value exceeds the total premiums paid.
  
  
• Sale of a Policy - If you opt to sell your policy, particularly if there’s substantial cash value involved, this could prove more financially beneficial than surrendering. When a policy with or without cash value is sold, the policyholder can receive a better return. However, the financial upshot includes intricate tax consequences that aren’t immediately evident.

Tax Implications for Policyholders - IRS taxes life settlement proceeds using a three-tier system.

1. Premiums Paid: Returns up to the amount of the premiums paid generally aren't taxed.
   
   
2. Taxable Gain Ordinary Income: Proceeds up to the policy’s cash surrender value over the amount of premiums paid are taxed as ordinary income.
   
   
3. Capital Gains Tax: Amounts that exceed the cash surrender value are subject to capital gains tax.
   
   Example 1 - Surrender of Policy - John held a life insurance policy that accumulated cash value over time. After eight years, he decided to surrender the policy, receiving its cash value of $78,000. This amount included a deduction of $10,000 for the "cost of insurance." Over the life of the policy, John had paid a total of $64,000 in premiums. Consequently, John realized a gain of $14,000, calculated by subtracting the premiums paid ($64,000) from the cash surrender value ($78,000). Because surrendering a life insurance policy does not yield a capital gain, this $14,000 is considered ordinary income for tax purposes.
   
   Example 2 - Sale of Policy with Cash Value - Consider the same initial scenario, but instead of surrendering the policy, John sells it to George, an unrelated party who has no personal financial stake in John's death. John receives $80,000 from the sale. This results in a gain of $16,000, calculated by subtracting the premiums he paid ($64,000) from the sale price ($80,000). Of this gain, $14,000—the amount by which the cash value exceeds the premiums paid—is considered ordinary income. The remaining $2,000 is classified as a capital gain.

Viatical Settlements: A Specific Scenario - Any amounts received under a life insurance contract on the life of a terminally ill individual are excluded from tax gross income. Excludable amounts received under a life insurance contract by chronically ill individuals are limited to the cost of qualified long-term care services.

Definitions:

• Terminally Ill Individual - the term “terminally ill individual” means a person who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months of the date of certification.
  
  
• Chronically Ill Individual – a “chronically ill” individual is one who has been certified within the previous 12 months by a licensed health care practitioner as:
  
  (A) being unable to perform, without “substantial assistance” from another individual, at least two activities of daily living for at least 90 days due to a loss of functional capacity,
  
  (B) having a similar level of disability as determined under IRS regulations prescribed in consultation with the Dept of Health and Human Services, or
  
  (C) requiring “substantial supervision” to protect the individual from threats to health and safety due to “severe cognitive impairment,” even if the individual is physically able.

Information Reporting - All parties involved in life settlement deals must adhere to IRS requirements for information reporting. This includes Form 1099-LS for life settlement transactions and Form 1099-SB for surrendering a policy or being part of a life settlement.

Final Thoughts - Life settlements, viatical settlements, and the broader financial implications they involve are complex. With overlapping rules and potential financial advantages, navigating these waters requires a thorough understanding of not only the transactions themselves but the ever-evolving tax implications they incur. Don’t hesitate to reach out for tailored advice or to discuss your specific situation. Whether you have questions about potential settlement values, tax responsibilities, or require guidance in reporting requirements, our office is equipped to provide comprehensive assistance.