It’s a commonly-held belief that proceeds from a viatical settlement aren’t taxed like ordinary income. While that’s generally true, there are specific conditions that must be met by the policyholder and the company that purchases the life insurance policy.
For people who have been diagnosed with a terminal illness and have a life expectancy of fewer than 24 months, selling a permanent life insurance policy through a viatical settlement can offer much-needed funds. Viatical settlements that do not fall under the specified tax exemptions may be taxed at the same rate as ordinary income. For this reason, it’s important to be familiar with IRS rules and regulations about what constitutes a qualifying viatical settlement.
Understanding your life insurance policy’s coverage
If the permanent life insurance policy in question has an accelerated death benefit or living benefit, it’s possible to keep the policy in force and preserve some of the face value while also receiving a tax-free lump sum cash payment.
There aren’t any restrictions on how to use the money. Getting cash out of a life insurance policy by accessing a rider or participating in a viatical settlement isn’t like making a health insurance claim. Many people who are terminally ill use money from a viatical settlement or accelerated death benefit to pay for uncovered or experimental medical treatment, to eliminate debts for the good of their families, to finance a trip they’ve always wanted to take.
Requesting an accelerated death benefit from the insurance company doesn’t mean you have to give up your life insurance policy. It’s possible to request a portion of the death benefit in exchange for a reduction in the policy’s face value. When policyholders are diagnosed with a terminal illness or a critical illness that requires long-term care, they may be able to draw from their life insurance policy’s face value as a source of cash if they have a long-term care rider.
This insurance add-on has less-strict standards to meet than accelerated death benefits. It provides money for long-term care after a physician has determined that the insured person is not able to handle normal everyday activities on their own like getting out of bed, getting dressed, using the bathroom, or managing medications.
If long-term care is needed, the distributions from the life insurance rider to pay for those services are tax-free. Requirements for accessing an accelerated death benefit or long-term care rider may vary from one insurance company to the next. Policyholders who are terminally ill and do not have additional riders included with their life insurance policy often consider selling their policy to a group of investors through a viatical settlement.
Viatical settlement tax laws
The taxation of viatical settlements changed in 1995 when the federal government passed the Health Insurance Portability and Accountability Act (HIPPA). Under this law, both accelerated death benefits and proceeds from a viatical settlement are tax-free to terminally ill policyholders with a less than 24-month life expectancy. There’s no limit to the amount of money a terminally ill policyholder can receive tax-free through a viatical settlement.
Before the HIPPA laws went into effect, proceeds from a viatical settlement were treated like ordinary income by the IRS. To qualify for the tax-free status under the current law, the following conditions must be met:
- The insured person must have less than 24 months to live according to a doctor. State taxes may vary, but most states have laws that look like the HIPPA guidelines regarding income from viatical settlements.
- The policyholder must be an individual. Businesses that own a life insurance policy on a terminally ill person may not sell that policy through a viatical settlement and get tax-free status.
- The company purchasing the life insurance policy must be licensed in the state where the viator You can learn more about state laws regarding viatical settlements and find out about a specific company’s licenses by contacting your state’s attorney general.
- The company purchasing the life insurance policy must also regularly purchase policies from terminally ill people via the viatical settlement process.
The HIPPA laws about which companies are considered a “qualified viatical settlement provider” also govern how much money an insured person should receive if they decide to sell their life insurance policy. The company must adhere to the National Association of Insurance Commissioners (NAIC) Viatical Settlements Model Act Sections 8 and 9, which sets forth definitions for reasonable payment amounts.
Here are the Minimum Payment Guidelines of the NAIC:
- Life expectancy of 1-6 months receives 80% of the face value of the policy
- Life expectancy of 6-12 months receives 70% of the face value of the policy
- Life expectancy of 12-18 months receives 65% of the face value of the policy
- Life expectancy of 18-24 months receives 60% of the face value of the policy
- Life expectancy of 24-36 months receives 50% of the face value of the policy
When you decide to sell your life insurance through a viatical settlement to pay for medical treatment, to cover living expenses, or to help you cross some big dreams off your bucket list, you are making a financial decision that will affect your beneficiaries.
If you don’t qualify for tax-free status in a potential viatical settlement but are still interested in selling your life insurance policy, you may have other options available to you. According to the IRS, the proceeds from a viatical settlement may be taxed like ordinary income if the conditions mentioned above aren’t met. In some cases, a viatical settlement is a good option even if there are tax implications. Consult a tax professional to understand how you’ll be taxed if you get a large lump sum of money through the sale of your life insurance policy.
There’s a lot of moving parts in a viatical settlement, and before making a decision you should be sure how the proceeds from your potential settlement may be taxed. You can get an estimate of how much money your life insurance policy may be worth in a life settlement or viatical settlement, here.