For those looking to monetize their assets and supplement their income in retirement, life settlements an provide attractive tax benefits such as tax-free portions of settlement funds and, under certain conditions, complete tax exemption. To fully understand the tax policy under each component of a life settlement payout, it is often helpful to divide the sale proceeds and their tax implications into the three following categories.
- Tax Basis. Policyholders can enjoy any funds tax-free that are received through a life settlement and are equal or less than the sum of all paid premiums (this sum is referred to as the tax basis).
- Cash Surrender Value. When the proceeds exceed the tax basis, any difference between the policy’s cash surrender value and tax basis is taxed as ordinary income.
- Remaining Proceeds. Any sale proceeds that are beyond the policy’s cash surrender value are taxed as capital gains.
While the above tax rules hold in most cases, there are two instances in which all of the proceeds from selling your life insurance policy would be completely exempt from any taxation: when the insured individual is either terminally or chronically ill A person is considered terminally ill when a physician certifies that their illness or condition has limited their life expectancy to within 24 months.
An individual with a chronic illness is defined as someone who a licensed healthcare practitioner has certified as unable to perform two or more activities of daily living (ADLs) unassisted. Examples of ADLs that certify chronic illnesses are eating, walking, bathing, and dressing. When individuals meet the criteria for either of the above conditions, their life insurance sales are called viatical settlements, and all of the funds from the sales are free of taxes.
Disclaimer: Retirement Genius does not offer tax or legal advice. This material has been prepared for informational purposes only and should not be relied upon for tax or legal advice. Retirement Genius urges you to consult with your own tax or legal advisors before entering into any transaction.