How Life Settlement Taxes Work


We recommend that you reach out to your financial and tax advisor prior to making the decision to sell your life insurance. We have designed this chapter as an introduction to understanding the tax treatment and implications of a life settlement – this however does not replace the advice of a tax expert who may be better able to navigate your personal circumstances.

Tax treatment of life settlement proceeds

Generally speaking, the tax code provides that gross income includes income from all sources, including gains from a life insurance contract. However, life settlement taxation can be a complicated topic. While, it is safe to say that gain in excess of the cost of the policy 0 or the cost of insurance – will be taxed as ordinary income, it is important to get expert tax advice before closing a sale.

The misconception that a life settlement is a non-taxable transaction may stem from the unique tax feature of a life insurance policy. The death benefit in a life insurance policy is tax-free – which has made the acquisition of a life insurance policy very attractive, especially to transfer wealth from one generation to the next.

While death benefits paid to the beneficiaries are nontaxable –  when the proceeds of the settlement are paid to an individual other than the policy holder, they can be taxed at both the federal and state level. The usual treatment is that earnings in excess of the cost of insurance are taxed.

A real-life example of the taxes

Let’s take Bobby.

Bobby is a 75-year old retiree, who does not have a critical illness but decides to sell his life insurance policy to pay down outstanding debts.

In this exercise, we will determine the amount of the taxable income recognized on the sale of Bobby’s life insurance contract.

  • Step 1: What was Bobbys insurance cost?

As a policyholder, Bobby can obtain full credit for the amount of premiums he has paid when he surrendered your policy.

However, the Tax Code has different rulings when it comes to a sale to a third party. In a Life Settlement, the amount of premiums paid does not necessarily reflect the accurate value of the policy; this is because a life insurance is both an investment and a contract. Indeed, the IRS assumes that a portion of the premiums paid accrued to your benefit, as you have sold your life insurance policy.

Assuming Bobby has paid total premiums of $200,000 at the date of the settlement, and that the insurance carrier deducted $40,000 from the policy’s cash surrender value, this leaves Bobby with a cash surrender value of $160,000. The cash surrender value is a good approximation of the cost of insurance.

  • Step 2: What was Bobbys capital gain?

Now let’s assume that the life settlement Bobby received is $250,000.

Assuming the cash surrender value above of $160,000 – this means Bobby must recognize $90,000 on the sale (Settlement Value – Cost of Insurance).

The profit on a sale of a life insurance contract falls under “substitute for ordinary income”.

Does this ruling apply to everyone?

Not exactly.

The Internal Revenue Code has a different tax treatment to life policy holders who are critically or terminally ill, in cases of “Viatical Settlement”. They can receive the payment tax free.

Policy holders who are not terminally ill are not extended the same privilege. A life settlement transaction generates taxable income based upon the gain you receive on the sale of your life insurance.

As explained in the example above, the gain – which is taxable, is the difference between your policy’s sales price and the cost of insurance or the total premiums paid minus the cost of insurance besides nontaxable dividends you may have received under your contract.

One of the primary advantages to a life settlement is that you can potentially get more money for the policy than by surrendering it to the insurance company or by letting the term of the insurance lapse—in which you get absolutely nothing. While the taxation of life settlements is complicated, it is not difficult to understand.