When a Michigan resident sells a life insurance policy in 2026, federal law taxes the proceeds in three tiers — the amount up to your premium basis is tax-free, the gain up to the policy’s cash surrender value is ordinary income, and anything above that is capital gain — and Michigan then applies its flat individual income tax, approximately 4.25% as of 2026 (confirm the current rate), to the gain that lands in state taxable income. Viatical settlements by terminally ill insureds are the standout exception: those proceeds are generally free of income tax altogether.
The framework is friendlier than most sellers expect. The 2017 federal tax law removed the old requirement to reduce basis by the cost of insurance, and IRS Revenue Ruling 2020-05 confirmed the cleaner three-tier math — so more of a typical settlement comes back tax-free than under the pre-2018 rules.
This guide works through each tier with real dollar figures, then adds Michigan’s layer. It is education, not tax advice: bring your actual policy numbers to a CPA before you sell, and certainly before you file.
In This Article
- The Federal Three-Tier Rules (2026)
- A Worked Example: $200,000 Policy, $50,000 Sale
- Michigan’s Layer: A Flat ~4.25% on the Gain
- The Viatical Exception: Generally No Income Tax at All
- Settlements, Michigan Medicaid, and Care Planning
- Reporting: Forms 1099-LS and 1099-SB
- Keeping Perspective: Taxes Rarely Change the Answer
- Frequently Asked Questions
The Federal Three-Tier Rules (2026)
Under the post-TCJA framework clarified by Rev. Rul. 2020-05, settlement proceeds divide into three layers:
- Tier 1 — tax-free return of basis. Everything up to your basis — generally total premiums paid, with no reduction for cost of insurance — comes back untaxed.
- Tier 2 — ordinary income. The gain between basis and the policy’s cash surrender value is ordinary income. Note this is the same amount you would owe tax on if you simply surrendered the policy.
- Tier 3 — capital gain. Proceeds above the cash surrender value are long-term capital gain, usually taxed at lower federal rates.
The cash surrender value is the hinge of the whole calculation — it separates the ordinary-income layer from the capital-gain layer. If you are not sure what yours is, our primer on cash surrender value explains how to read it off your annual statement or request it from the insurer.
A Worked Example: $200,000 Policy, $50,000 Sale
Take a Grand Rapids retiree with a $200,000 universal life policy. He has paid $28,000 in premiums over the years (his basis). The cash surrender value is $34,000, and a settlement provider offers $50,000.
- Tier 1: The first $28,000 is a tax-free return of basis.
- Tier 2: The next $6,000 ($34,000 CSV − $28,000 basis) is ordinary income.
- Tier 3: The final $16,000 ($50,000 − $34,000) is long-term capital gain.
Federally he pays his bracket rate on $6,000 and capital-gain rates on $16,000; well over half the check is untaxed. Had he surrendered for $34,000 instead, he would have reported the identical $6,000 of ordinary income — but pocketed $16,000 less. That asymmetry is the heart of the settlement-versus-surrender comparison: the extra money a settlement pays is taxed at the gentler capital-gain rate, while the taxable gain you would owe anyway stays the same.
Michigan’s Layer: A Flat ~4.25% on the Gain
Michigan keeps the state side simple. The individual income tax is a flat rate — approximately 4.25% as of 2026 (the rate has moved slightly in recent years with revenue triggers, so confirm the current figure) — applied to Michigan taxable income, which starts from federal adjusted gross income. Both the ordinary-income tier and the capital-gain tier of a settlement generally flow into that base; Michigan does not offer a preferential rate for capital gains.
For the retiree above, the state bill is roughly 4.25% of the $22,000 taxable portion — about $935. Michigan also offers retirement and pension subtraction rules that have been phasing back in for many taxpayers, but settlement gain is not pension income and should not be assumed to qualify for those subtractions; that nuance alone is worth a CPA conversation. Some Michigan cities, including Detroit, levy their own income taxes on residents, which can add roughly 1% to 2.4% depending on the city — check whether yours does.
| Layer | Amount (Example: $50,000 Sale) | Federal Treatment (2026) | Michigan Treatment (2026) |
|---|---|---|---|
| Tier 1: Up to premium basis | First $28,000 | Tax-free return of basis | Tax-free |
| Tier 2: Basis to cash surrender value | Next $6,000 | Ordinary income | ~4.25% flat rate (verify current rate) |
| Tier 3: Above cash surrender value | Final $16,000 | Long-term capital gain | ~4.25% — no state capital-gain preference |
| City income tax | Varies | N/A | Some cities (e.g., Detroit) add roughly 1–2.4% for residents |
| Viatical settlement (life expectancy ≤ 24 months) | Entire proceeds | Generally excluded under IRC §101(g) | Generally follows federal exclusion |
| Reporting forms | — | 1099-LS (buyer), 1099-SB (insurer) | Federal figures flow to MI-1040 |
The Viatical Exception: Generally No Income Tax at All
If the insured is terminally ill — physician-certified life expectancy of 24 months or less — the transaction is a viatical settlement, and IRC Section 101(g) generally excludes the entire proceeds from federal income tax, provided the buyer meets the statute’s requirements (licensed as a viatical settlement provider where licensing exists). Chronically ill insureds can also receive favorable treatment when proceeds go toward qualified long-term-care costs, under additional rules.
Because Michigan’s income tax starts from federal AGI, a federally excluded viatical settlement generally escapes Michigan tax as well. Michigan’s statute specifically regulates viatical transactions — see our Michigan licensing guide — so for terminally ill insureds both the regulatory protections and the tax exclusion line up. Get the physician certification and buyer qualifications documented carefully; they are the keys to the exclusion.
Settlements, Michigan Medicaid, and Care Planning
Many Michigan settlements happen because care bills are looming, which brings Medicaid into the tax conversation. The net proceeds are a countable asset until spent, but selling at fair market value is not a gift — it avoids the five-year-lookback penalties that giving a policy away would trigger. The asset limits (about $2,000 countable for a single applicant as of 2026) and spend-down mechanics are covered in our guide to Michigan Medicaid asset and income limits.
One coordination point families miss: taxes shrink the net available for care. If your settlement will generate taxable gain, reserve the federal and Michigan tax before committing every dollar to a nursing home contract, so the following April does not arrive with the money gone.
Reporting: Forms 1099-LS and 1099-SB
Settlement transactions generate their own IRS paperwork. The buyer reports the purchase on Form 1099-LS, and your insurance company reports your basis and surrender value on Form 1099-SB. Together they give your preparer — and the IRS — the numbers for the three-tier calculation, which then flows through to your Michigan MI-1040. Keep both forms, plus your own premium-payment history, with the year’s records.
If your premium records are spotty, request a policy history from the insurer before closing. Basis you cannot document is basis you may effectively lose, and every dollar of documented basis is a dollar of the settlement that comes back tax-free.
Keeping Perspective: Taxes Rarely Change the Answer
After all the layers, the arithmetic usually still favors the settlement when a policy is unaffordable or unneeded. The federal GAO found settlements typically pay 10% to 35% of face value — on average about 4 to 8 times cash surrender value — and Michigan’s modest flat tax takes a small slice of only the gain portion. The truly tax-free path, holding until death, is right only when premiums remain payable and the coverage is still doing a job; see what policies qualify for how the market evaluates that trade-off.
The sensible sequence: get a real offer via a free policy review, have your CPA compute the after-tax net against surrender and lapse, then decide with actual numbers. Call (305) 209-7183 or start in our Education Center.
Frequently Asked Questions
Are life settlement proceeds taxable in Michigan?
Partially. Federal rules make proceeds up to your premium basis tax-free, tax the gain up to cash surrender value as ordinary income, and treat the rest as capital gain. Michigan then applies its flat income tax — about 4.25% as of 2026 — to the gain portions. Have a CPA run your specific numbers.
What is Michigan’s income tax rate on a settlement gain?
Michigan’s individual income tax is a flat rate of approximately 4.25% as of 2026, applied to both the ordinary-income and capital-gain layers — the state has no preferential capital-gains rate. Confirm the current rate, since Michigan’s has shifted slightly with revenue triggers in recent years.
Do Michigan cities tax life settlement gains too?
Possibly. A number of Michigan cities levy resident income taxes — Detroit’s is the largest — typically adding roughly 1% to 2.4% on taxable income. Whether your settlement gain is touched depends on your city of residence. Check your city’s rules or ask your preparer.
Are viatical settlements tax-free for Michigan residents?
Generally yes. When the insured has a physician-certified life expectancy of 24 months or less and the buyer meets the requirements of IRC Section 101(g), the proceeds are excluded from federal income — and because Michigan starts from federal AGI, the state tax generally falls away too. Documentation of the certification is essential.
How do I prove my basis in the policy?
Basis is generally the total premiums you paid. The insurer reports its figures on Form 1099-SB when you sell, but your own records matter: request a full premium history from the insurance company before closing if your files are incomplete. Documented basis is the tax-free layer of your settlement.
Is surrendering better for taxes than selling?
Rarely. Surrender triggers ordinary income on the same gain above basis, but pays only the cash surrender value — while the federal GAO found settlements averaging 4 to 8 times that amount. The settlement’s extra dollars above surrender value are taxed at capital-gain rates, which usually beats leaving them on the table.
Will a settlement affect my Michigan Medicaid eligibility?
The net proceeds count as an asset until spent, so timing matters if long-term-care Medicaid is in the picture. Selling at fair market value is not a gift and creates no lookback penalty; the cash must then be spent down compliantly. An elder law attorney can sequence the sale and the application.
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Related Reading
- Cash Surrender Value Life Insurance
- Life Settlement Vs Surrender
- What Policies Qualify For Life Settlement
- Michigan Medicaid Asset Income Limits
- Life Settlement Licensing Michigan
- 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.