Selling a life insurance policy, especially through a life settlement, might feel like uncovering hidden treasure—one that could bring in a decent chunk of money. But as with anything involving cash and Uncle Sam, taxes are going to come into play. If you’re wondering what the IRS wants from your life settlement sale, you’re in the right place. We’re breaking it all down in everyday terms, so you won’t need a finance degree to follow along.
Overview
Life settlements are becoming more common, especially as people realize that life insurance policies aren’t set in stone. If you no longer need or can’t afford the premiums, or just want to cash out, selling your policy might make sense. But don’t forget—when you sell a policy, it’s considered a financial transaction. And as with most financial transactions, it can come with tax consequences.
In this article, we’ll walk you through what a life settlement is, how taxes factor in, the IRS rules you need to know, and how different scenarios might affect your tax bill. We’ll also look at what you can do to possibly reduce your tax liability. It’s not as scary as it sounds, promise.
What is a Life Settlement, and How Is It Taxed?
First, let’s get clear on what a life settlement actually is. A life settlement happens when you sell your life insurance policy to a third party—usually an investor. They give you a lump sum that’s more than your policy’s cash surrender value but less than the death benefit. After that, the buyer takes over paying premiums and becomes the policy beneficiary.
Sounds simple enough, right? Well, once that money hits your account, the IRS considers it income—and they want to take a slice.
Let’s look at the breakdown of how the IRS taxes life settlements. They typically split your gain into three parts:
| Portion | Tax Treatment | Explanation |
| Return of Investment (Basis) | Not Taxable | This is what you’ve paid in premiums over time. Think of it as your “cost.” |
| Ordinary Income | Taxed as Ordinary Income | Any amount you get that’s above your basis but under the policy’s cash value. |
| Capital Gains | Taxed as Capital Gains | If you sell the policy for more than its cash value, that extra amount is taxed. |
Let’s say you’ve paid $50,000 in premiums, your policy’s cash value is $60,000, and you sell it for $80,000. Here’s how that might be taxed:
- First $50,000 = Not taxable (return of investment)
- Next $10,000 (up to cash value) = Ordinary income
- Remaining $20,000 = Capital gains
Pretty straightforward when you break it down like that.
Key Tax Considerations for Life Settlement Sales
Here’s where things can get a little more nuanced. There are several factors that can affect how your life settlement sale is taxed.
Policy Type Matters
Not all policies are treated the same. Term life insurance policies don’t typically have a cash surrender value, so if you sell one, your entire gain over the basis might be taxed as capital gains. Whole or universal life policies often have cash value, which means your gain could be split between ordinary income and capital gains.
How Long You’ve Owned the Policy
Holding the policy for more than a year? That might qualify the capital gains portion for long-term capital gains treatment, which generally means a lower tax rate.
Your Cost Basis
This is essentially the total premiums you’ve paid into the policy. The more you’ve paid, the higher your basis—and the smaller your taxable gain. However, figuring out the exact basis can be a bit tricky. It’s not always as simple as “total premiums paid,” especially if you’ve taken loans or withdrawals.
State Taxes
Federal taxes are one thing, but don’t forget about your state. Some states tax life settlement proceeds, while others don’t. Make sure you check your local rules, or better yet, consult a tax professional.
Selling Due to Terminal or Chronic Illness
Good news here: If you’re terminally or chronically ill and meet specific IRS criteria, the proceeds from your life settlement may be excluded from income tax entirely. This is treated similarly to an accelerated death benefit. There are rules, of course, but this could be a huge relief if you qualify.
Tips to Navigate Taxation on Life Settlement Sales
Let’s run through some practical tips that can help keep things manageable (and possibly reduce your tax burden).
Keep Meticulous Records
Track your premium payments, policy loans, and any changes to your coverage. This info helps calculate your cost basis, which affects how much tax you might owe.
Talk to a Tax Pro
A CPA or tax advisor can make a huge difference when it comes to sorting out your taxable gain, especially if your policy or situation is complicated.
Consider a 1035 Exchange (Before Selling)
If you’re thinking about replacing one policy with another instead of selling, a 1035 exchange lets you do that without creating a taxable event. This isn’t a direct alternative to a life settlement, but it’s worth exploring.
Explore Tax-Exempt Scenarios
If you’re selling due to a qualifying terminal or chronic illness, find out if your proceeds might be exempt. You might be able to keep the entire payout tax-free.
Compare Buyers
Not all offers are equal. Beyond the payout amount, ask how each buyer handles tax reporting. Some may offer guidance or even tax reporting help as part of the deal.
Review IRS Guidelines
IRS Revenue Ruling 2009-13 and IRS Form 1099-LS (and 1099-SB) are the main documents covering life settlement reporting. These rules can help clarify how your sale is reported and what documentation you’ll receive.
FAQs
Is the money from a life settlement taxable?
Yes, most of the time. Depending on how much you’ve paid into the policy and how much you sell it for, some of the payout could be tax-free, while the rest may be taxed as ordinary income or capital gains.
Do I have to report a life settlement to the IRS?
Yes. The company buying your policy will typically file a Form 1099-LS with the IRS and send you a copy, showing the proceeds you received. You’ll need to include that info when you file your taxes.
What if I donated my policy or gave it to a family member?
That’s a whole different tax situation—possibly involving gift tax or charitable deductions. Consult a pro for this one.
What if I sold the policy for less than the premiums I paid?
In that case, you likely have a capital loss. Whether or not you can deduct that loss depends on several factors, and it’s worth checking with a tax advisor.
Conclusion
Life settlements can offer a financial lifeline, especially if you no longer need your policy or want to free up some cash. But before you jump in, it’s crucial to understand the tax implications. While a good portion of your payout might be tax-free, the rest could be subject to ordinary income and capital gains taxes.
Every situation is different. Your policy type, how long you’ve had it, your health status, and your cost basis all play into the tax equation. The best move? Be proactive. Get your records in order, talk to a tax expert, and weigh all your options before signing on the dotted line.
And remember, life insurance is supposed to give you peace of mind—so don’t let tax confusion stress you out. With the right information and a little planning, you can make the most of your life settlement and avoid surprises come tax time.