For a Connecticut resident, life settlement proceeds are taxed in three federal tiers — the amount up to your premium basis comes back tax-free, the gain up to the policy’s cash surrender value is ordinary income, and anything above that is capital gain — and Connecticut then taxes the gain portion again at its state income-tax rates, which top out at approximately 6.99% as of 2026 (verify current-year rates). Viatical settlements for the terminally ill are the big exception: under IRC Section 101(g), a seller with a life expectancy under 24 months generally owes no income tax on the proceeds at all.
The three-tier federal framework was settled after the 2017 tax law and the IRS’s follow-up guidance in Revenue Ruling 2020-05, which also simplified basis: you no longer subtract the cost of insurance from your premiums when computing basis. That change made the math friendlier to sellers than it was a decade ago.
This page walks through each tier with a worked dollar example, shows how Connecticut layers on top, and flags the traps — but it is education, not advice. Before you sell, run your actual numbers with a CPA or tax attorney who knows Connecticut returns. A free policy review (just send your policy’s cover page) can tell you what a sale might gross before you spend anything on tax planning. Call (305) 209-7183.
In This Article
- The Federal Three-Tier Framework, Explained
- A Worked Example: $250,000 Policy, $48,000 Sale
- How Connecticut Taxes the Gain on Top
- The Viatical Exception: Terminal Illness Changes Everything
- Term Policies, Underwater Policies, and Other Edge Cases
- Settlement Proceeds, Medicaid, and Connecticut Spend-Down Planning
- Get the Gross Number First, Then Plan the Net
- Frequently Asked Questions
The Federal Three-Tier Framework, Explained
When you sell a life insurance policy for more than nothing, the IRS splits the proceeds into up to three slices (post-TCJA rules, confirmed in Rev. Rul. 2020-05):
- Tier 1 — return of basis, tax-free. Your basis is the total premiums you paid into the policy (reduced by any untaxed withdrawals or dividends taken in cash). Sale proceeds up to that number are simply your own money coming back.
- Tier 2 — ordinary income. The gain from your basis up to the policy’s cash surrender value (CSV) is taxed as ordinary income — the same rates as wages. The logic: this is the slice you could have realized by surrendering, and surrender gain has always been ordinary.
- Tier 3 — capital gain. Anything the buyer pays above the CSV is capital gain. If you have owned the policy for more than a year — almost always true — it is long-term capital gain, taxed at the lower federal capital-gains rates.
One important 2017-law improvement: sellers no longer reduce basis by the “cost of insurance” embedded in their premiums. Basis is simply premiums paid, which raises the tax-free tier for nearly every seller compared with the old rule.
A Worked Example: $250,000 Policy, $48,000 Sale
Numbers make the tiers concrete. Suppose a 74-year-old Connecticut resident sells a $250,000 universal life policy in 2026:
- Total premiums paid (basis): $30,000
- Cash surrender value at sale: $38,000
- Settlement price: $48,000
The federal slices:
- Tier 1: the first $30,000 (up to basis) — tax-free.
- Tier 2: $38,000 − $30,000 = $8,000 of ordinary income.
- Tier 3: $48,000 − $38,000 = $10,000 of long-term capital gain.
So of $48,000 received, only $18,000 is taxable at all, and $10,000 of that gets capital-gains treatment. Compare the alternative: surrendering for $38,000 would have produced the same $8,000 of ordinary income but $10,000 less cash. This spread — more money, with the extra slice taxed at favorable rates — is why the sell-versus-surrender comparison in our life settlement vs. surrender guide so often favors at least getting a quote. Note the example is illustrative, not a projection of any offer; real pricing depends on age, health, and premiums, with the GAO’s market study (GAO-10-775) finding typical settlements of 4–8 times surrender value.
How Connecticut Taxes the Gain on Top
Connecticut has a broad-based personal income tax with graduated rates, and as of 2026 the top marginal rate is approximately 6.99% (verify the current-year brackets — Connecticut has adjusted its lower brackets in recent years). The state starts from federal adjusted gross income, so the taxable slices from Tiers 2 and 3 flow onto the Connecticut return automatically.
Two Connecticut-specific points worth knowing:
- No preferential capital-gains rate. Unlike the federal system, Connecticut taxes capital gains as ordinary income at its regular rates. The Tier 3 slice that enjoys reduced federal rates gets no similar break on the state return.
- Retiree income exemptions do not cover settlement gain. Connecticut phases out tax on Social Security and certain pension/IRA income for lower- and middle-income retirees, but gain from selling a life insurance policy is not pension income and does not ride those exemptions.
Using the worked example above, the $18,000 of federally taxable gain would also be Connecticut-taxable — at the resident’s marginal state rate, up to roughly 6.99% — adding on the order of a few hundred to about $1,250 of state tax depending on total income (illustrative; confirm with a preparer).
| Slice of Proceeds | Federal Treatment (2026) | Connecticut Treatment (2026) |
|---|---|---|
| Up to premium basis | Tax-free return of basis (Rev. Rul. 2020-05; no cost-of-insurance reduction) | Not taxed (state starts from federal AGI) |
| Basis up to cash surrender value | Ordinary income | Taxed at regular CT rates, top ~6.99% (verify) |
| Above cash surrender value | Long-term capital gain (if held > 1 year) | Taxed at regular CT rates — no state capital-gains preference |
| Viatical sale, life expectancy ≤ 24 months | Generally excluded under IRC §101(g) | Generally excluded (follows federal income) |
| Chronically ill seller, proceeds used for care | Excludable within limits under §101(g) | Follows federal treatment |
| Reporting forms | 1099-LS (buyer) and 1099-SB (carrier) filed with IRS | Gain flows onto CT resident return automatically |
The Viatical Exception: Terminal Illness Changes Everything
Federal law carves out the hardest cases entirely. Under IRC Section 101(g), if the insured is terminally ill — certified by a physician as having a life expectancy of 24 months or less — the sale of the policy to a licensed viatical settlement provider is generally treated like a death benefit: income-tax-free, at both the federal level and, because Connecticut starts from federal income, generally the state level too.
A related but narrower rule covers the chronically ill: proceeds can be tax-free to the extent used for qualified long-term-care costs, subject to conditions and caps. The certification, the buyer’s licensing status, and the use of proceeds all matter to the exclusion, so this is precisely where a tax professional earns their fee.
If a Connecticut family is facing a terminal diagnosis and holds a policy that is about to lapse or be surrendered, the viatical rules mean the after-tax comparison is even more lopsided than usual — and the state’s settlement act adds consumer protections for exactly this situation, covered in our Connecticut licensing and regulation guide.
Term Policies, Underwater Policies, and Other Edge Cases
Term insurance. A convertible term policy usually has no cash value, so there is no Tier 2: proceeds above basis are generally capital gain. Basis questions on term policies are technical (the IRS has treated most term premiums as consumed coverage), so get specific advice before assuming a large tax-free tier.
Policies where basis exceeds the sale price. If you paid more in premiums than the buyer pays you, there is generally no taxable gain at all — the entire payment is a partial return of your own money. Whether the shortfall produces a deductible loss is a separate, usually unfavorable, question for your preparer.
Outstanding policy loans. A loan balance extinguished at sale counts as part of your amount realized, which can create taxable gain even when the cash you pocket is modest. Get the loan figure into the calculation early.
1099 reporting. Since the 2017 law, settlement buyers file Form 1099-LS reporting the sale, and carriers file Form 1099-SB reporting your basis. The IRS sees the transaction; report it correctly. Understanding your policy’s cash surrender value before you sell is essential, because that single number sets the boundary between your ordinary-income and capital-gain tiers.
Settlement Proceeds, Medicaid, and Connecticut Spend-Down Planning
Taxes are only half the after-sale math for many Connecticut families; the other half is benefits eligibility. Settlement proceeds are countable assets, so a seller applying for long-term-care Medicaid (HUSKY C in Connecticut) must plan how the money will be spent. The good news: selling a policy at fair market value is not a gift, so it does not trigger the five-year lookback penalty — it converts an illiquid countable asset into spendable funds that can pay for care during a compliant spend-down.
The details — Connecticut’s asset limits, spousal protections, and spend-down pathway — are covered in our companion guide to Connecticut Medicaid asset and income limits. If adult children are worried about a parent’s unpaid facility bills, Connecticut’s filial responsibility law is also worth understanding. Coordinating the sale, the taxes, and the Medicaid timeline is a job for an elder-law attorney; the point of this page is that the pieces interact and should be planned together, not discovered in sequence.
Get the Gross Number First, Then Plan the Net
Tax planning on a hypothetical is wasted effort. The efficient order for a Connecticut policyholder in 2026: (1) find out whether the policy is a realistic settlement candidate and roughly what it might bring; (2) take that range to a CPA or tax attorney and model the federal tiers plus the state’s roughly 6.99% top rate; (3) if care funding or Medicaid is in the picture, loop in an elder-law attorney before signing.
Step one is free. Send the policy’s cover page — the first page showing the carrier, face amount, and policy type — for a no-obligation review, or call (305) 209-7183. The typical secondary-market profile is an insured 65 or older with a policy of $100,000 or more; the full process, if you proceed, runs about 60 to 120 days, which leaves room for the tax planning to happen properly. More background on the market’s mechanics lives in our Education Center.
Frequently Asked Questions
Are life settlement proceeds taxable in Connecticut?
Partially, in most cases. Federally, proceeds up to your premium basis are tax-free, gain up to the cash surrender value is ordinary income, and any excess is capital gain. Connecticut then taxes those gain slices at its regular income-tax rates, topping out around 6.99% as of 2026. The major exception is a viatical settlement by a terminally ill insured, which is generally income-tax-free under IRC Section 101(g).
Does Connecticut tax capital gains from a life settlement at a lower rate?
No. Connecticut taxes capital gains as ordinary income at its standard rates — there is no state-level preferential capital-gains rate. The slice of your settlement above cash surrender value gets reduced federal capital-gains rates, but on the Connecticut return it is taxed the same as the rest of your income, at up to roughly 6.99% as of 2026.
How do I figure out my basis in a life insurance policy?
Your basis is generally the total premiums you have paid, reduced by any dividends received in cash or untaxed withdrawals. Since the 2017 tax law, you no longer subtract the internal cost of insurance, which makes basis higher and the tax-free tier larger. Your insurance carrier reports basis on Form 1099-SB when a policy is sold, but request an in-force statement of premiums paid before the sale so you can check the number.
What if I am terminally ill — do I owe tax on selling my policy?
Generally no. Under IRC Section 101(g), a sale by an insured certified by a physician as having a life expectancy of 24 months or less, made to a licensed viatical settlement provider, is treated like a death benefit and excluded from income tax. Because Connecticut’s income tax starts from federal income, the exclusion carries through to the state return. The certification and the buyer’s licensing must be handled correctly, so involve a tax professional.
Will selling my policy affect my Connecticut Medicaid eligibility?
It can, and it should be planned. Settlement proceeds are countable assets for long-term-care Medicaid (HUSKY C). Selling at fair market value is not a gift, so it does not create a lookback penalty — but the cash must then be spent down compliantly, typically on care, before eligibility. An elder-law attorney can sequence the sale and the application; our Connecticut Medicaid guide covers the 2026 limits.
Is the IRS notified when I sell my life insurance policy?
Yes. Since the 2017 tax law, the buyer files Form 1099-LS reporting the sale and the payment, and your insurance carrier files Form 1099-SB reporting your basis in the contract. The transaction is fully visible to the IRS, so report it on your return using the three-tier framework. A CPA familiar with Rev. Rul. 2020-05 can prepare the calculation in minutes once the numbers are in hand.
How is a term life policy taxed when sold?
A term policy usually has no cash surrender value, so the ordinary-income tier mostly disappears: proceeds above your basis are generally capital gain. Basis on term insurance is a technical question because the IRS has viewed most term premiums as paying for consumed coverage, so do not assume every premium dollar counts. Get specific advice — convertible term policies are regularly sold, and the tax answer is usually favorable but fact-dependent.
Should I get tax advice before or after getting a settlement offer?
Get the offer range first, then the advice. Tax planning on a hypothetical number wastes professional fees. A free policy review — which requires only the policy’s cover page — tells you whether the policy is a realistic candidate and a rough value range. Take that range to a CPA or tax attorney who prepares Connecticut returns, and model the federal tiers plus state tax before you sign anything. The 60-to-120-day settlement timeline leaves ample room for this.
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Related Reading
- Life Settlement Vs Surrender
- Cash Surrender Value Life Insurance
- Life Settlement Licensing Connecticut
- Connecticut Medicaid Asset Income Limits
- Filial Responsibility Law Connecticut
- Education Center
Pine Lake Life Solutions does not purchase life insurance policies and does not provide legal, tax, or investment advice. Information provided is for educational purposes only. Eligibility for any option, including life settlements, is not guaranteed and depends on individual circumstances, policy terms, underwriting, and market conditions. Consult independent legal, tax, or financial professionals before making decisions regarding a life insurance policy.