How are the proceeds of a life settlement taxed?

Life settlements have been gaining popularity recently, but many people don't know how they are taxed. Today we explore what a life settlement is, a little bit about its history, and the potential tax implications to consider before pursuing this type of settlement.

A life settlement is the sale of a life insurance policy to a third-party investor for more than its cash surrender value, but less than its death benefit. Essentially, the policy owner receives a lump sum payment in exchange for transferring ownership of the policy to the investor. The investor takes over the payment of premiums and collects the death benefit when the insured passes away.

Life settlements were invented in the early 1990s as an option for policy owners who no longer needed or could no longer afford their life insurance policies. Life settlements were primarily used by elderly policy owners who needed cash to pay for medical expenses or other financial obligations. However, the market has expanded in recent years to include a wide range of policy owners, including younger and healthier individuals.

The taxation of life settlements is determined by the IRS. How much tax is owed is determined by several factors, including the policy owner's cost basis in the policy, the proceeds received from the settlement, and the premiums paid by the investor after the settlement. The taxation of life settlements can be complex, but the Tax Cuts and Jobs Act of 2017 simplified the process by establishing a new default rule for determining the tax basis of a life insurance policy.

Under the new rule, the tax basis of a life insurance policy is generally equal to the sum of the premiums paid for the policy, less any dividends or withdrawals made from the policy. This means that the taxable amount of the proceeds received from a life settlement is generally equal to the excess of the settlement amount over the policy's tax basis.

However, there are some exceptions to the new rule, particularly for policies that were transferred to the policy owner by gift or inheritance. Additionally, it's worth noting that the taxation of life settlements can vary depending on many factors, including the policy owner's tax bracket, the type of policy being sold, and the terms of the settlement agreement.

If you're considering a life settlement, it's crucial to understand how the proceeds will be taxed and to consult with a qualified tax professional before making any decisions.