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A Fundamental Overview of Life Settlement Taxation


For a few of your high-net-worth shoppers, the monetary technique of liquidating life insurance coverage through a life settlement comes with tax implications. 

Life settlement taxation is ruled by the Tax Cuts and Jobs Act of 2017 (TCJA), signed into regulation by former President Trump in early-2018. TCJA created a extra favorable tax construction for policyholders by simplifying the associated fee foundation definition.

Immediately, the associated fee foundation of a life settlement is the cumulative premiums paid on the offered coverage. Pre-TCJA, the associated fee foundation was complete premiums paid much less the price of insurance coverage (COI). This was problematic for 2 causes:

  1. COI usually wasn’t accessible to policyholders
  2. Lowering premiums by COI resulted in a decrease value foundation

Since proceeds as much as the policyholder’s value foundation aren’t taxable, the decrease value foundation triggered a bigger tax burden for promoting policyholders.

Life Settlement proceeds above the associated fee foundation are taxable in two tiers:

  1. Proceeds over the associated fee foundation and as much as the coverage’s money give up worth are taxed as extraordinary revenue.
  2. Proceeds over and above the coverage’s money give up worth are taxed as long-term capital good points.

Think about a coverage that sells for $110,000. If the policyholder paid $50,000 in cumulative premiums, the whole taxable achieve is $60,000. Assuming a money give up worth of $55,000, $5,000 of the $60,000 achieve is taxable on the policyholder’s revenue tax price. The IRS treats the remainder of the achieve — $55,000 — as a long-term capital achieve.

State Taxation of Life Settlements

Promoting policyholders can also owe state taxes of their dwelling state. Every state’s tax remedy of life settlements aligns with the state’s normal strategy to revenue and capital good points taxes. There are three situations:

  1. In states that do not accumulate taxes on revenue or funding good points, policyholders will solely pay federal taxes on life settlement proceeds.
  2. In states that do not supply a decrease capital good points price, the policyholder’s state revenue tax price will apply to the whole taxable achieve, or internet proceeds much less cumulative premiums.
  3. In states which have their very own guidelines for capital good points, policyholders would first calculate the 2 tiers of good points as dictated by TCJA. The state’s revenue price would apply to the revenue portion of the proceeds, and the state’s regular capital good points guidelines would apply to the remainder.

After-Tax, Proceeds Exceed the Money Worth

No matter the place the policyholder lives, the after-tax proceeds from a life settlement will exceed the proceeds generated by surrendering the life insurance coverage coverage. Utilizing the numbers from the instance above, the policyholder can both give up that coverage for $55,000 or promote it for $110,000.

After dealer commissions, federal taxes, and state taxes, the web money proceeds from the $110,000 sale will nonetheless be greater than the $55,000 money give up worth.  After all, this assumes no main adjustments to the tax code that applies to life settlements or the revenue tax and capital good points tax charges.

Whereas the Biden administration pitched massive tax price will increase on high-income people within the 2021 American Households Plan, there hasn’t been ample congressional help for that effort to this point. For now, policyholders can think about the life settlement as a technique to maximise the worth of their life insurance coverage. Regardless that the achieve on the transaction is taxable, the web proceeds can be greater than the coverage’s money give up worth.

A seasoned tax skilled can assess how the extra achieve will have an effect on the policyholder’s total tax burden for the 12 months.

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