Are Life Settlements Taxable?

Are you considering a life settlement? These transactions can net policyholders far more cash than their policy’s surrender value, and are a great way to turn a burdensome premium payment into liquid assets. Many people choose to pursue a life settlement late in life to add to their retirement savings and reduce worry about outliving their assets.

If you’ve been considering this option, you should be aware of the federal taxes associated with selling a life insurance policy. These large transactions are sure to help you meet your financial needs, but as with any major financial decision, you should be aware of all of its ramifications, including its tax treatment.

*Lighthouse life created this post for information purposes and does not provide tax advice. While this article provides general information about how life settlements are taxed, please consult a tax professional for questions about your specific situation.

While there are multiple settlement types, each with their own potential tax ramifications, the Tax Cuts and Jobs Act (TCJA) of 2017 simplified the federal tax code for life settlements. This means you shouldn’t have to spend too much time deciphering tax codes and can more easily understand what you may owe, if anything.

In this article, we’ll explore the latest information on how life settlements are affected by federal taxes, and what you can do to minimize the tax burden of your settlement.

How Are Life Settlements Taxed?

The amount of federal taxes you will pay on a life settlement has an inverse correlation with the amount of premiums you have paid into the policy. The type(s) of the tax(es) you will potentially need to pay is affected by the difference between the cash surrender value and the settlement value.

In simpler terms, the more premiums you’ve already paid on your policy, the lower the federal taxes on your life settlement will be.

This is best explained through an example. Let’s imagine that you have a life insurance policy with a cash surrender value of $3,000 on which you’ve paid $41,000 in premiums during the life of the policy. If you were to receive a settlement of $60,000, you would determine your federal tax obligation in the following manner.

• To determine what will be classified as “taxable income” by the IRS, subtract the value of premiums paid from the settlement value. In this case $60,000 – $41,000 = $19,000. That $19,000 is classified as taxable, while the $41,000 of paid premiums is tax free.
• Cash value that is greater than the premiums paid is taxable as ordinary income. If the cash value is less than the premiums paid, none of the settlement will be taxed as ordinary income. In this example, because the cash value is less than the total premiums paid, none of the proceeds are taxable as ordinary income.
• The total taxable proceeds minus the proceeds taxed as ordinary income are considered long term capital gains. In this example, $19,000 – $0 = $19,000 of the settlement would be considered long term capital gains and subject to that tax.
• Once you put all of this together you arrive at the following federal tax breakdown:
  • $41,000 of your $60,000 settlement is tax-free
  • $0 of your $60,000 settlement would be taxable as ordinary income
  • $19,000 of your $60,000 life settlement would be taxable as long-term capital gains

Here are a few other scenarios:

• $15,000 settlement, $20,000 paid in premiums, $0 cash value
  • The entire $15,000 settlement will be tax free federally
• $45,000 settlement, $20,000 paid in premiums, $25,000 cash value
  • $20,000 is tax free
  • $5,000 taxable as ordinary income
  • $20,000 taxable as long-term capital gains
• $30,000 settlement, $18,000 paid in premiums, $7,500 cash value
  • $18,000 is tax free
  • $0 taxable as ordinary income
  • $12,000 taxable as long-term capital gains
• $9,000 settlement, $17,000 paid in premiums, $2,700 cash value
  • The entire $9,000 settlement will be tax free federally

Can I Receive a Tax-Free Life Settlement?

Many life settlements end up untaxed federally, as the amount of premiums paid often exceeds the final value of the payout. Even in instances where taxes will be applied, it’s worth noting that a settlement is still the best way to receive a worthwhile payout on your life insurance while still alive, and to recoup some or all of the cost of the premiums you’ve paid in over the years.

If you plan to pursue a life settlement with your existing life insurance, we recommend speaking with a tax professional as well. If you do not already have a tax specialist you work with, we highly recommend seeking one out.

How to File Taxes on a Life Settlement

If you’ve already taken a life settlement or want to know how to pay taxes on one before you pursue the option, here’s a general breakdown.

After determining how much of your settlement will be taxable, and the categories in which those taxes will be applied, your next step is to research the tax rates for those categories. As of January 2022, the federal income tax rate is based on a variety of factors, largely related to the amount of income made. We suggest following this guide to determine what your tax burden will be on the portion of the settlement that is taxed solely as income tax.

Long-term capital gains tax also varies depending on the amount accumulated. The currently listed rate (as of June 2022) of taxation for any amount below $40,400 is 0%. Any amount over that begins to be taxed at 15% and increases in percentage from there.

As always, we suggest consulting with a tax professional when you pay taxes on a life settlement. A quality tax professional will ensure that you pay the correct amount, which will keep you free of any tax penalties from the IRS.

Are You Eligible for a Life Settlement?

Now that you know how a life settlement is taxed by the IRS, it’s time to see if you qualify for a life settlement. Get started by filling out our simple form or giving us a call to see if you qualify. At Lighthouse Life, we work tirelessly to help people like you turn your life insurance policy into cash that can help you lead a more comfortable life in retirement. Contact us today and turn your outdated policy into cash now!