A little background
Before jumping further into how life settlement taxation works in these scenarios, there are some terms you need to learn in order to understand.
Beneficiaries are the person or people –of your choosing– that will receive a cash payment when the covered person dies.
Life settlements and taxes
Life insurance settlements are taxable once you make a profit.
According to the Tax Cuts and Jobs Act of 2017, a profit from a life settlement is considered the difference between the premiums you paid and the lump sum payout you received when you sold your policy.
Part of the lumpsum payment you receive could be taxed like regular income and another part as capital gains.
It can be summed up in 3 steps:
- The lumpsum payment amount from the sale of the policy that is equal to the premiums you paid is tax-free.
- The lumpsum payment amount from the sale of the policy that is above the premiums you paid and up to the policy’s cash surrender value is taxed as ordinary income.
- Any money from the lumpsum payment that exceeds the prior two points is taxed as long-term capital gains.
Viatical settlement and taxes
A viatical settlement is when a chronically or terminally ill person decides to sell their life insurance policy to a third party in exchange for a lump-sum payment that is less than their death benefit. The payout is also tax-free.
Death benefit and taxes
If you decide against cashing out on your life insurance and then pass away, a death benefit needs to be paid out to the beneficiaries that you chose. That lump sum payment, generally, is not considered taxable income. In some situations, however, that is not the case.
If the policyholder decided that they wanted the insurance company to hold the lump sum payment for a couple of months before paying it out in full to the beneficiary, then the interest that the policy earned during that time would be taxable.
Another situation where someone would have to pay taxes on a death benefit would be if the policyholder decided that they wanted their death benefit to be paid out to an estate. Then, the person inheriting the estate may have to pay estate taxes.