Rather than surrender your life insurance policy for the cash surrender value, there is a market available that allows you to sell your life insurance policy for cash, for potentially greater amounts of money than had you chosen to surrender the policy to the life insurance company.
In the following article, we will briefly touch on the life settlement and viatical settlement marketplace and then address how the sales of life insurance policies are taxed.
What is a Life Settlement?
A life settlement is a transaction that occurs between a policy owner and an investor.
The investor purchases a policy from the policy owner in return for cash.
Once the transaction has completed, the investor becomes the new life insurance policy owner and is responsible for maintaining the policy.
Upon the death of the insured (typically the previous policy owner, although it is possible for the owner and insured to be two different people), the investor receives the lump sum death benefit payout.
Life Settlement vs Viatical Settlement
Often the terms life settlement and viatical settlement are used interchangeably. However, it is possible to make a distinction between the two.
A viatical settlement is one someone sells their life insurance policy upon discovering they are terminally ill with less than a 2 year life expectancy.
A life settlement is the sale of a life insurance policy by someone who is over the age of 65 with a life expectancy that ranges from 2 years up to 10 years. Depending on the life settlement company that range may be higher.
The Best Life Insurance Policies to Sell
Any life insurance policy may be considered for a life settlement, which includes term life, whole life and universal life.
However, the main ingredient a life settlement company will consider is if the policy will outlast you.
For example, you would probably be hard pressed to find a buyer of a term policy set to expire in 3 years if your life expectancy is 5 years or more.
Why Do People Sell Life Insurance Policies?
The main reason would be to get cash. If you are sitting on a policy with a large death benefit you may be tempted to cash it in to use the money for whatever you choose.
Another reason you might consider selling your life insurance is because you can no longer keep up with your insurance premiums. Rather than miss premium payments and risk the policy either lapsing, eating away at your cash value, or being changed to a reduced paid-up policy, choosing to sell it might be the best route for your specific circumstances.
The bottom line is life changes. You may need the cash, maybe you can’t make the payment or perhaps you simply do not want or need the coverage any longer. The good news is there are options for you.
However, one thing you need to consider is the tax consequences of selling you life insurance policy.
How Are Sales of Life Insurance Policies Taxed
When life insurance policy owners no longer want, need, or can afford to continue to pay policy premiums, they traditionally have surrendered their policies to the issuer for their cash surrender value.
If the policyholder surrenders a cash value life insurance policy on his life for the cash surrender value, the excess of the cash surrender value of the policy over the tax basis (which equals what the policyholder has paid in premiums for the policy) equals ordinary income to the policyholder because the policy is not considered a capital asset.
However, an option now exists which enable policyholders to receive amounts more than cash surrender value by selling the policy on the life settlement market.
If the policy holder sells a life insurance policy on the life settlement market, the life settlement taxation consequences are more complicated.
This is because the sale of the life insurance policy, under these circumstances, is treated as, in part, the sale of a pure insurance asset (resulting in ordinary income), and as, in part, the sale of an investment asset (resulting in capital gain).
First, the basis (what the policyholder paid for the policy) is reduced by the amount of the premiums which covered the cost of the insurance that was in effect at the time of sale.
This is because a portion of the amounts paid represents the acquisition of the asset, and a portion represents the expenditure for life insurance coverage.
The difference between the amount received for the policy and basis as thus adjusted is the taxable gain recognized on the transaction.
The difference between the cash surrender value of the policy at the time of sale, and the original basis is ordinary income.
The IRS reasoned that this constituted ordinary income under the “substitute for ordinary income” doctrine articulated in several tax cases.
Result: The remaining gain is taxed as capital gains.
Thus, assuming a sale of a policy for which $64,000 in premiums have been paid, with $10,000 of the premiums paid for the cost of insurance, the adjusted basis is $54,000.
Assuming a cash surrender value of $78,000 and a sale price of $80,000, the difference between the $80,000 received and the $54,000 adjusted basis is gain.
Of that gain, the difference between cash surrender value ($78,000) and original cost basis ($64,000) is ordinary income ($14,000), and the remainder of the gain ($26,000 less $14,000) is capital gain ($12,000).
Term Life Insurance Settlement
If a policy with no cash surrender value is sold (for example a term life insurance contract), the policy premiums would have largely covered just the cost of insurance, so that the proceeds received from the sale of the policy would all be capital gains.
Convertible Term Life Insurance
This suggests that convertible term life insurance may be the most tax advantageous type of life insurance policy for life settlements.
It also suggests that when the redemption price of life insurance nears the life settlement value of a policy, careful consideration needs to be given to determine whether the additional tax burden of selling on the life settlement market justifies the transaction.
Article written in part by:
Eric S. Ratliff, JD, LLM
Ratliff Law Firm
740 Pollard Road
Kodak, TN 37764
(865) 932-3441 x704
Well certainly, if you have a universal life or whole life policy — and you need money urgently, or maybe you’re just tired of paying those increased premium rates — and you’re 65 to 70 years old, in that age range — selling your life insurance policy sure makes more sense to me thank simply letting it lapse or surrendering it. No doubt about it.
Yes, life settlements are definitely worth a look at vs letting your policy lapse. And yes, you will sometimes get more cash when selling than simply surrendering the policy for its cash value.
sold a policy for $42,500.00. Had paid premiums of $120,750.00. Surrender value was $40,000.00. have no idea of the cost of insurance. Will I have any tax to pay? Looks like the numbers would be negative by perhaps $78,250. can these losses be used to reduce other capitol gains or income?
Hello Hal and thanks for commenting. While we write about these topics for educational purposes, we can’t venture into offering actual tax advice. I suggest you connect with your CPA or tax attorney about this. Best, Steve Gibbs, for I&E