Introduction
One of the most important questions policyholders ask before considering a life settlement is:
- How are life settlements taxed?
- Is selling a life insurance policy taxable income?
- Do I pay capital gains on a life settlement?
- Is surrender taxed differently than a life settlement?
Tax treatment directly affects net proceeds. Understanding the federal framework before evaluating an offer is essential.
If you are unfamiliar with the broader concept of life settlements, begin here:
Read More: How It Works & Policy Options
This article explains the general federal tax structure applicable to life settlements under current IRS guidance. It is provided for educational purposes only and does not constitute tax advice.
High-Level Tax Summary (Quick Reference)
In general, life settlement proceeds may be divided into three potential tax categories:
- Return of cost basis (often not taxable)
- Ordinary income portion
- Capital gain portion
The exact breakdown depends on:
- Total premiums paid (cost basis)
- Cash surrender value
- Total settlement proceeds
- Policy structure
- Individual tax profile
Each transaction must be evaluated individually.
What IRS Authority Governs Life Settlement Taxation?
The primary IRS guidance addressing life settlements is Revenue Ruling 2009-13. You can review the official IRS document here.
This ruling clarified how gain is treated when a life insurance policy is sold to a third party. Historically, tax treatment was inconsistent and often misunderstood. The IRS ruling distinguished between:
- Tax treatment of policy surrender
- Tax treatment of policy sale (life settlement)
- Allocation of gain categories
Later, the Tax Cuts and Jobs Act of 2017 clarified cost basis calculation rules, resolving earlier ambiguity about whether cost of insurance charges reduced basis in sale transactions.
Together, these developments established the modern framework for life settlement taxation.
How Is Cost Basis Calculated?
Cost basis generally refers to the total premiums paid into the policy. Under current interpretation:
- Total premiums paid are typically used as cost basis
- Cost of insurance charges are not deducted from basis for sale purposes
- Policy loans and prior withdrawals may affect adjusted basis
Accurate basis calculation is essential because taxation is determined by comparing:
Settlement proceeds
minus
Cost basis
minus
Cash surrender value
Even small adjustments in basis can materially affect taxable gain. A qualified tax professional should calculate basis before determining net proceeds.
How Does the IRS Categorize Life Settlement Proceeds?
The IRS framework divides life settlement proceeds into layers. Understanding why these layers exist is key. Life insurance policies accumulate value internally over time. When a policy is sold, the IRS treats different portions of the payout differently based on economic character.
1️⃣ Return of Basis (Typically Not Taxable)
To the extent settlement proceeds do not exceed total premiums paid, that portion is generally considered recovery of capital.
Example:
If total premiums paid equal $250,000 and the settlement payout is $240,000, the entire amount may represent return of basis. No gain exists.
2️⃣ Ordinary Income Portion
If proceeds exceed the policy’s cost basis up to the amount of the cash surrender value, that portion is generally treated as ordinary income.
Why?
Because the internal growth of a life insurance policy (cash value accumulation) would have been taxed as ordinary income if withdrawn or surrendered. The IRS preserves that character.
3️⃣ Capital Gain Portion
Any proceeds received above the cash surrender value may be treated as capital gain. This portion reflects value paid by the secondary market above the insurer’s internal policy value.
It is this additional market premium that may qualify for capital gains treatment under current interpretation.
Illustrative Example (Conceptual Framework)
Consider a simplified scenario:
- Total premiums paid: $250,000
- Cash surrender value: $300,000
- Life settlement offer: $400,000
Tax layering may work conceptually as follows:
- First $250,000 → Return of basis (not taxed)
- Next $50,000 (up to $300,000 surrender value) → Ordinary income
- Final $100,000 (amount above surrender value) → Capital gain
Actual outcomes depend on individual tax circumstances and should be verified professionally. This layered structure is what distinguishes life settlement taxation from surrender taxation.
How Is Policy Surrender Taxed?
Surrender treatment differs materially. When a policy is surrendered:
- Any amount received above cost basis is generally taxed as ordinary income
- Capital gains treatment does not typically apply
This means that surrender eliminates the potential for capital gain categorization that may exist in a life settlement.
Read More: Surrender vs. Life Settlement: Key Differences
Are Life Settlements Ever Tax-Free?
In limited circumstances, certain viatical settlements may receive favorable tax treatment if:
- The insured is terminally ill (as defined by the IRS)
- The transaction meets federal definitions
Read More: Life Settlements vs. Viatical Settlements
Most standard senior life settlements are taxed under the layered framework described above.
Do State Taxes Apply?
Possibly.
Many states follow federal tax classification. Others apply independent rules. State income tax may apply to:
- Ordinary income portion
- Capital gain portion
Consult state-specific guidance or a qualified advisor.
How Do Policy Loans Affect Taxation?
Outstanding policy loans can complicate tax outcomes. Loan balances may:
- Reduce net proceeds
- Trigger taxable gain if the policy lapses
- Alter basis calculation
Loan payoff treatment must be evaluated carefully before surrender or sale.
Can a Life Settlement Affect Medicaid or Public Benefits?
Yes. Receiving a lump-sum payment may affect:
- Medicaided eligibility
- Means-tested benefits
- Long-term care planning strategies
Proceeds may count as assets. Planning should occur before proceeding.
Read More: Risks of Selling a Life Insurance Policy
Frequently Asked Questions
1. Do I pay capital gains tax on a life settlement?
Possibly. Amounts received above the policy’s cash surrender value may qualify for capital gains treatment, depending on IRS classification and individual circumstances.
2. Is a life settlement fully taxable?
No. Portions may represent return of basis, ordinary income, and capital gain. Taxation depends on structure and cost basis.
3. Is surrender taxed differently than selling the policy?
Yes. Surrender proceeds above basis are generally taxed as ordinary income. Life settlements may include a capital gain component.
4. Can taxes eliminate the benefit of a life settlement?
Tax impact varies. Net proceeds should be evaluated after tax analysis to determine whether a life settlement provides economic advantage over surrender. For more common questions, visit our FAQ page.
Key Takeaways
Life settlement taxation is not a flat rate. It depends on:
- Total premiums paid (cost basis)
- Cash surrender value
- Total settlement amount
- IRS classification under Revenue Ruling 2009-13
- Individual tax profile
It is not automatically tax-free. It is not automatically fully taxable. Proper evaluation requires professional analysis.
Read More: Who Qualifies for a Life Settlement?
Read More: How the Life Settlement Process Works
Ready to evaluate your policy’s potential value? Start an Educational Review with our team today.