Mastering the Art of Life Insurance Settlements and Taxation in 2024

What You Need to Know

Viatical settlements have one set of rules.
Traditional life settlements have another.
States may have rules of their own.

The tax notices are flowing in.

Seniors, life insurance agents, financial advisors and accounting professionals are thinking about tax preparation. Questions often arise about the taxation of life insurance settlements.

It’s essential to seek guidance from a tax professional, but understanding the basics can provide a solid foundation for helping clients make informed decisions.

Viatical and Life Settlements Basics

There are two main categories of life insurance policy sales: viatical settlements and life settlements.

Viatical settlements: This term applies to transactions involving seniors or others with a terminal illness that’s expected to result in death within 24 months.

For clients who make viatical settlement deals, the proceeds are typically tax-free.

In addition, if the insured is chronically ill, the settlement proceeds may not be taxed.

The IRS defines a chronically ill individual as “someone who has been certified (at least annually) by a licensed health care practitioner as being unable to perform, without substantial assistance from another individual, at least two daily living activities (eating, toileting, transferring, bathing, dressing, and continence) for at least 90 days due to a loss of functional capacity.”

Or a person “requiring substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment.”

Traditional life settlements that are taxed in tiers:

First tier (tax-free): Proceeds from the settlement that equal your client’s tax basis are not subject to tax.

The tax basis typically includes the total premiums paid on the policy.

For instance, if the settlement amount is $100,000 and your client’s tax basis (the total premiums paid) is $50,000, there is no tax on this initial $50,000.

Second tier (ordinary income tax): Proceeds that exceed your client’s tax basis but are less than or equal to the policy’s cash surrender value are taxed as ordinary income.

Continuing the example, if the policy’s cash surrender value is $80,000, and your client’s basis is $50,000, the next $30,000 of the settlement proceeds will be taxed as ordinary income.

Third tier (capital gains tax): Any proceeds that surpass the cash surrender value of the policy are subject to capital gains tax.