Life Settlement Taxation
Making a nice return on any type of investment is a good thing, even if Uncle Sam and your state government want a piece of the proceeds. We’re talking about taxes, of course, which should be a consideration in any major asset sale, life settlements included.
Sometimes, the worst part isn’t paying those ordinary income and capital gains taxes — it’s the burden of interpreting complicated tax codes to understand how much, exactly, you’ll owe on a given transaction. That is definitely the case with respect to taxation on life settlements. It doesn’t help things that the IRS has changed its position on the tax treatment of these transactions more than once. Thankfully, the latest update — ushered in with the Tax Cuts and Jobs Act of 2017 (TCJA) — is slightly less complicated for taxpayers to understand and follow.
Are life settlements taxable?
So, are life settlements taxable? The easy answer is yes, life settlements are taxable to the extent you make a profit. What’s tricky about life settlement taxation, though, is that “profit” can mean different things according to the IRS. Prior to 2018, the IRS’ approach to calculating profit on life settlement contracts was vague enough to dissuade seniors from even pursuing the sale of their life insurance policies. Instead, they’d leave money on the table by letting their unwanted life insurance lapse.
The Tax Cuts and Jobs Act of 2017 (TCJA) simplified life settlement taxation substantially. Today, the profit of your life settlement is defined as the difference between the premiums you paid and the cash payout you received from the sale. Some of that profit is taxed as ordinary income and some is taxed as capital gains, depending on how your cost on the policy compares to the policy’s cash surrender value when it was sold.
History of life settlement taxation
Just a few decades ago, the life settlement market didn’t exist. It came into its own under fairly morbid circumstances. At the height of the AIDS epidemic in the 1980s, younger, terminally ill life insurance policyholders needed cash to cover their healthcare expenses. That population drove the supply that created a market for viatical settlements, which are life insurance policy sales by terminally ill policyholders. Once the market for viatical settlements started to grow, it paved the way for the elderly to sell their life insurance policies, even without a terminal diagnosis.
The life settlement market began in earnest in the ’90s and started gaining momentum in the early 2000s.
When you consider that the New York Stock Exchange opened in 1817 — 200 years ago — the 20-year history of life settlements is relatively short. It’s not surprising, then, that the IRS has been indecisive about the tax treatment of these somewhat new financial transactions. In the early years, the IRS was actually silent on the appropriate way to tax life settlements. That silence was followed by a 2009 ruling which was subsequently replaced by the TCJA at the end of 2017.
Revenue Ruling 2009-13
The IRS issued Revenue Ruling 2009-13 in May of 2009. The ruling clarified the tax treatment of selling a life insurance policy to a third party or surrendering a policy back to the insurer. Revenue Ruling 2009-13 went into effect immediately, and specified two sets of rules, one applying to transactions prior to August 26, 2009, and one applying to transactions on or after that date.
Prior to August 26, 2009, the IRS assumed that the cost basis on life settlements equaled the cumulative amount of premiums paid by the insurer. Under that definition, any sale proceeds up to the seller’s total investment in premiums were tax-free. Sale proceeds in excess of premiums paid were taxable in two tiers. The difference between the cash surrender value and the cost basis was taxed as ordinary income. Any remaining proceeds over that amount were taxed as capital gains.
The tax treatment for settlements on or after August 26, 2009, though, got really messy. The ruling laid out three sets of guidelines for different situations: the surrender of a life insurance policy for cash value, the sale of a term life policy, and the sale of a whole life policy.
Revenue Ruling 2009-13 tax treatment on cash-value surrender
Under Revenue Ruling 2009-13, a surrender of life insurance back to the insurer would be taxed on the difference between the net cash received by the insured and the total premiums paid, less any loans or withdrawals. The insured’s ordinary income tax rate would be used to calculate the tax.
Let’s look at how this works with an example. Say Mrs. Jones no longer wants her life insurance. She is told by her insurer that the cash surrender value is $50,000. Mrs. Jones held that policy for 30 years and she has invested $42,000 total in premiums. Her effective federal tax rate on ordinary income is 18%.
Mrs. Jones would calculate her federal tax burden on the cash surrender as follows:
- Cash surrender value of $50,000 less premiums paid of $42,000 equals a taxable gain of $8,000.
- The 18% tax rate on the $8,000 gain equals federal taxes of $1,440.
Revenue Ruling 2009-13 tax treatment on sale of term insurance
Revenue Ruling 2009-13 specified a different approach for term life policies, which don’t have a cash surrender value. In this case, the cost basis equals the total premiums paid less charges for the cost of insurance. If the insured has no data on the cost of insurance, this is assumed to be the same as the policy’s premium. The difference between the sale proceeds and the cost of insurance is taxed entirely as a capital gain.
Let’s assume Mr. Jones sells his term life policy to an investor for $15,000 after keeping the policy in force for 75.5 months. Mr. Jones made 76 monthly premium payments of $100 each. Here’s how he’d calculate the taxes:
- 76 payments of $100 each equals total premium payments of $7,600.
- The cost of insurance equals the premium multiplied by 75.5, which is the time the policy was owned by Mr. Jones. His total cost of insurance would be $7,550.
- The cost basis is the total premiums less the cost of insurance. So, Mr. Jones paid in $7,600 and his cost of insurance totaled $7,550. That leaves a cost basis of $50.
- Mr. Jones would pay long-term capital gains tax on $14,950, which is the proceeds of $15,000 less the cost basis of $50.
- Assuming a 15% federal capital gains tax rate, Mr. Jones owes $2,242.50 in federal taxes, or 15% of $14,950.
Revenue Ruling 2009-13 tax treatment on sale of whole life policy
In this scenario, let’s go back to Mrs. Jones and her whole life policy with a cash value of $50,000. Instead of surrendering her policy, Mrs. Jones decides to pursue a life settlement. She works through Harbor Life Settlements to receive a competitive offer of $58,000, net of broker fees, for her policy.
To calculate the taxes under Revenue Ruling 2009-13, Mrs. Jones would need the cost of insurance from her insurer — a number which may or may not be available in real life. But for this example, let’s assume her insurer confirms that the total cost of insurance is $8,000.
Mrs. Jones’ gain is taxed in two tiers. The difference between the cash surrender value and her cost basis is taxed as ordinary income, and any gain above that amount is taxed as a long-term capital gain. Here’s the math:
- Mrs. Jones’ cost basis is $34,000. She gets to that number by subtracting the $8,000 total cost of insurance from the $42,000 that she paid in premiums.
- The taxable gain on the sale is $24,000, calculated as the $58,000 in proceeds less the basis of $34,000.
- The portion of the proceeds that’s taxed as ordinary income is the policy’s cash surrender value of $50,000 less the basis of $34,000. That equals $16,000.
- Using Mrs. Jones’ effective tax rate of 18%, the tax on that portion of the gain is $2,880.
- The remainder of the gain, $8,000, is taxable at the lower capital gains rate. Assuming she’s taxed on capital gains at 15%, that adds $1,200 to her tax liability on this transaction.
- Mrs. Jones’ total tax is $2,880 plus $1,200, or $4,080.
Your head’s spinning, right? Yeah, policyholders and tax specialists didn’t like this approach much either. One point of contention was the difference between the taxation on life settlements versus policy surrenders. Specifically, life settlement taxation required policyowners to reduce their cost basis by the cost of the insurance, which was not a requirement on policy surrenders. The rationale was to separate the insurance portion of the policy from the investment portion. But calculating the cost basis that way proved to be problematic for policyowners — who often couldn’t get the cost of insurance from their insurers.
Thankfully, the IRS simplified the taxation on life settlements in a big way with TCJA.
Tax Cuts and Jobs Act of 2017 (TCJA)
TCJA was signed into law in December of 2017 and mostly went into effect on January 1, 2018. Under TCJA, whole life settlements and policy surrenders now both use the total premiums paid as the cost basis on the transaction. That has two benefits for policyholders: It streamlines the calculations and lowers the overall tax bill.
How Does Life Settlement Taxation Work?
TCJA retains the three-tier tax structure as defined in the Revenue Ruling 2009-13. To recap:
- Sale proceeds up to the amount of the cost basis are not taxable.
- Sale proceeds above the cost basis and up to the policy’s cash surrender value are taxed as ordinary income.
- Any remaining sale proceeds are taxed as long-term capital gains.
The big difference is that policyowners no longer have to reduce their cost basis by the cost of insurance. If we look back at Mrs. Jones’ life settlement, her cost basis under Revenue Ruling 2009-13 was $34,000. Under TJCA, it’s $42,000. As with any transaction, if all else is equal, a higher cost basis means a lower gain. And a lower gain means lower taxes.
Here’s the breakdown of how the TCJA treatment works out for Mrs. Jones:
- Mrs. Jones’ cost basis is the total premiums paid of $42,000 in premiums paid.
- The gain on the sale is the $58,000 in proceeds less the basis of $42,000, which equals $16,000.
- The difference between the cash surrender value of $50,000 and the cost basis of $42,000 — $8,000 — is taxed as ordinary income. At her effective tax rate of 18%, that equals $1,440.
- The remaining gain of $8,000 is taxed as a capital gain. Assuming a capital gains tax rate of 15%, that’s another $1,200 in tax.
- Mrs. Jones’ total tax is $1,440 plus $1,200, or $2,640 — $1,440 less than she would have paid under Revenue Ruling 2009-13.
Below is a side-by-side comparison at the taxation for this transaction, before and after TCJA.
|Under Revenue Ruling 2009-13, on or after August 26, 2009||Under TCJA|
|Less cost of insurance||($8,000)||NA|
|Sale price of policy||$58,000||$58,000|
|Less cost basis||($34,000)||($42,000)|
|Cash surrender value||$50,000||$50,000|
|Less cost basis||($34,000)||($42,000)|
|Gain taxed as ordinary income||$16,000||$8,000|
|Tax at 18% effective tax rate||$2,880||$1,440|
|Less gain taxed as ordinary income||($16,000)||($8,000)|
|Gain taxed as capital gain||$8,000||$8,000|
|Tax at 15% capital gains rate||$1,200||$1,200|
State Tax Consequences When Selling Your Life Insurance
The above analysis is specific to federal taxation on life settlements, but you may owe state taxes on the transaction, too. How much you owe obviously hinges on how your state taxes ordinary income and capital gains. There are three general scenarios. Either your state taxes capital gains as ordinary income, your state offers preferential tax treatment for capital gains, or your state levies no income taxes or capital gains taxes at all.
Your state taxes capital gains as ordinary income
No special capital gains rate or tax treatment in your state? In this case, you’d pay your effective state income tax rate on the entire taxable gain as calculated by TCJA.
If Mrs. Jones is a California resident paying an effective state tax rate of 7%, her state taxes on the transaction would be 7% of the $16,000 taxable gain, or $1,120. That brings her total federal and state tax burden to $3,760.
Your state has preferential tax treatment for capital gains.
These nine states offer some type of specialized tax treatment for your capital gains:
- New Mexico
- North Dakota
- South Carolina
Some of these states allow you to deduct a portion of your capital gains from your state’s return — which effectively lowers the rate you pay. Others define a lower rate that’s specific to capital gains.
If you live in one of these states, you’d follow the TCJA guidelines to define the “ordinary income” portion of your gain and the “capital gains” portion. Then, you’d follow your state’s tax rules to figure the tax. New Mexico, for example, allows you to deduct half of your capital gains, and then the remainder is taxed as ordinary income. Assuming a state tax rate of 4.9%, the New Mexico tax on Mrs. Jones’ life settlement would be calculated as:
- The first $8,000 of the gain is taxed at 4.9%, which equates to $392.
- The remainder of the gain is 50% deductible. That means Mrs. Jones only pays taxes on $4,000 of the “capital gains” portion. The same tax rate of 4.9% is applied. That adds $196, bringing her total state tax liability to $588.
Your state has no tax on ordinary income and no capital gains tax.
No state income tax? If you live in one of nine states that doesn’t tax ordinary income or capital gains, you won’t pay any state taxes on your life settlement at all. These nine states are:
- New Hampshire
- South Dakota
Your tax bill on the life settlement in these states is limited to what the feds will charge you.
Consult with a tax professional
The examples provided here for federal and state taxation on life settlements are for illustrative purposes only. Tax law is complicated, and your situation may demand a different tax treatment. Please consult with your tax advisor to get a more accurate estimate of the tax consequences of your life settlement.
There is one more takeaway. Selling your policy will create a higher taxable gain than surrendering it. Even so, your net cash proceeds after fees and commissions will still be higher with a life settlement. In Mrs. Jones’ cash, she nets $55,360 after taxes on her settlement, assuming she pays no state income tax. If she surrenders that policy, her take-home proceeds are $48,560 — about 12% less than she’d get from a life settlement.