It’s a stressful, troubling time when you or someone you love is considering a viatical settlement. Dealing with the chronic or terminal health conditions that make a settlement possible is emotionally demanding, to a level that’s beyond words. And while the sale of life insurance may ease financial worries and solve a few short-term problems, you’d still rather not be thinking about viatical settlements — and how they’re taxed — at all.
Unfortunately, taxation is not a subject to ignore when you’re considering any transaction that results in a cash payment to you. Overlooking a tax liability can get you into a different financial bind, either because you incur IRS penalties for under-withholding or you overestimate the transaction’s net proceeds. If you are exploring a viatical settlement as a way to convert your life insurance asset into cash, now is the right time to question the tax implications of that strategy.
Is a viatical settlement taxable?
Most of the time, viatical settlements are not taxable. Settlement proceeds for terminally ill insureds are considered an advance of the life insurance benefit. Life insurance benefits are tax-free, and so it follows that the viatical settlement wouldn’t be taxed, either.
But, of course, there are exceptions. If you’ve ever tried to read any U.S. tax code, it shouldn’t surprise you that the IRS imposes a list of conditions on tax-free viatical settlements. Some of those conditions apply to you, and others apply to the purchaser of your life insurance policy. All of these conditions must be met for you to retain your tax-free status. Even if you fulfill the requirements on your side, if your purchaser is not compliant, the settlement will be taxable.
You have another complication in play, too. State tax law is not consistent from state to state, and it can also change from year to year. Many states follow the federal taxation guidelines on viatical settlements, but some may not.
The gist is, viatical settlement tax treatment can vary depending on the details of your transaction. We’ll review the IRS’ general requirements below. But for a definitive opinion that considers your unique situation, you must have a thorough conversation with a qualified tax advisor.
Viatical settlement taxation: purchaser requirements
It might seem odd that the IRS imposes requirements on the purchaser in a viatical settlement. After all, you’re the one who will foot the tax bill, and you have little control over how a viatical settlement provider conducts business. But these rules are in place to protect you from unlicensed and unscrupulous providers. Your job is to know the requirements and avoid non-compliant purchasers whenever possible.
To be compliant, the purchaser of the policy must be recognized as a viatical settlement provider by the IRS. According to the IRS, a qualified, valid viatical settlement provider:
Has a history of regularly purchasing life insurance policies from terminally ill and chronically ill insureds. That means your second cousin or neighbor who decides to get licensed just to purchase your policy wouldn’t be considered ‘qualified’ by the IRS.
Is licensed in the state where the insured lives. Or, in states that don’t require licensing, the provider must follow the disclosure guidelines outlined in the Viatical Settlements Model Act by the National Association of Insurance Commissioners (NAIC). And specifically for terminally ill insureds, the provider must comply with the NAIC’s reasonable payments guidelines, which specify minimum payouts for policies based on the insured’s life expectancy. The shorter the life expectancy, the higher the payout.
If the purchaser doesn’t meet these requirements, the viatical settlement may be taxable.
Terminally ill insureds
If the purchaser is compliant and a physician has certified that the insured has less than 24 months to live, the viatical settlement proceeds are tax-free as long as the policyholder is an individual. Here are three scenarios to explain how that requirement works in practice:
Your terminally ill mom maintains a life insurance policy on herself. She is the insured and policyholder. This is the most typical situation. Assuming the viatical settlement meets the other requirements, the proceeds should be tax-free.
You hold a life insurance policy on your terminally ill mom. Your mom is the insured and you, an individual, are the policyholder. If the other requirements are fulfilled, the settlement proceeds to you should not be taxable.
Your terminally ill mom’s corporate employer has a life insurance policy on her. Even if the purchaser is compliant, the policyholder — a corporation — would be taxed on the proceeds of this viatical settlement.
Chronically ill insureds
The requirements are somewhat different when the insured is chronically ill, but not terminally ill. A chronically ill individual may have a more open-ended life expectancy, but is unable to perform two or more activities of daily living, also known as ADLs. ADLs are basic self-care tasks such as walking, eating, grooming, using the bathroom, bathing, and moving from one position to another.
If the insured is chronically ill, the viatical settlement is tax-free as long as the proceeds are used to cover out-of-pocket, medical, long-term care, or custodial expenses. Those are specifically the expenses that are not covered by Medicaid, health insurance, or long-term care insurance.
As you can imagine, there are viatical settlement scenarios that wouldn’t meet IRS requirements and, therefore, would be taxable. For example:
A chronically ill insured and policyholder wants to use the proceeds for something other than healthcare expenses
A terminally ill insured sells the policy and finds out, after the fact, that the purchaser is not recognized by the IRS as a valid viatical settlement provider
The insured has a non-curable, terminal disease with an expected lifespan that’s longer than 24 months. In this case, the insured could pursue a life settlement rather than a viatical settlement. Proceeds from life settlements are partially taxable
So, if you don’t qualify for a tax-free viatical settlement, then what? How are viatical settlements taxed? Good question. An experienced tax advisor will provide the most accurate answer, because it depends on why you don’t qualify. If you are chronically ill, for example, your tax advisor will likely recommend an approach that would fulfill your goals for how you want to use the proceeds, while minimizing your tax liability at the same time. On the other hand, if the IRS views your transaction as a life settlement and not a viatical settlement, your net cash would be taxed this way:
Proceeds up to the amount of total premiums paid are not taxable
If proceeds exceed total premiums paid, the policy’s cash surrender value less total premiums paid is taxed as ordinary income
All remaining proceeds are taxed as capital gains
Viatical settlement taxation takeaways
When you understand potential viatical settlement tax implications, you are better equipped to decide if a viatical settlement is indeed your best option. Here are five takeaways to remember about viatical settlement taxation.
Always consult with an experienced tax advisor. While viatical settlements aren’t normally taxed, there are nuances in these transactions that can have federal and/or state tax consequences.
Confirm if your state requires viatical settlement providers to be licensed. According to the Life Insurance Settlement Association, the only states that don’t regulate viatical settlements, as of September, 2018, are Alabama, Missouri, South Carolina, South Dakota, Wyoming, and Washington, D.C. Verify the current laws in your state by asking your tax advisor. If the state does not require licensing, then the provider must comply with disclosure guidelines and, for terminally ill insureds, payment guidelines in the NAIC’s Viatical Settlements Model Act.
Before accepting a viatical settlement offer, verify your prospective buyer is licensed if it’s required in your state. Or, if you are working with a broker, verify that your broker only markets your policy to qualified life settlement providers. This would be the case if you sell your policy through Harbor Life Settlements.
If the insured is terminally ill with an expected lifespan longer than two years, know that the settlement could be taxable. Discuss options with your financial advisor. It might make sense to wait on the settlement until the insured is within that two-year window. If you prefer not to wait, get familiar with the tax treatment of life settlements. Generally, some proceeds won’t be taxed, a portion will be taxed as capital gains, and the remainder will be taxed as ordinary income.
If the insured is chronically ill, have a good understanding of the out-of-pocket medical expenses before moving forward. Any proceeds in excess of those expenses are likely to be taxable.
The tax treatment of your viatical settlement is one factor of many to consider as you decide how to manage your life insurance going forward. Even if some of your viatical settlement proceeds are taxable, the selling your life insurance through a viatical settlement may still be the best option for you and your family. Only you can make the final decision, but we recommend you consult with a tax and/or financial advisor to ensure you have relevant, accurate information to guide you.
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