A Virginia resident who sells a life insurance policy in 2026 pays tax in three federal tiers — proceeds up to premium basis are tax-free, gain up to the cash surrender value is ordinary income, and the remainder is capital gain — with Virginia then taxing the gain portions at its ordinary income rates, which top out at 5.75% (2026 figure; verify current brackets). The major exception: viatical settlements for terminally ill insureds with a life expectancy under 24 months are generally income-tax-free under IRC Section 101(g).
Because Virginia’s top rate kicks in at a low income threshold, most of a settlement’s taxable portion is effectively taxed at a flat 5.75% by the Commonwealth — simpler to estimate than in states with steep graduated schedules, and considerably lighter than in high-tax states.
Below: the federal framework in plain English, Virginia’s layer, a worked dollar example, the viatical exception, and the questions for your tax preparer. This is education about how the rules work, not tax advice — your CPA runs your actual numbers.
In This Article
- How the Federal Rules Slice the Proceeds
- Virginia’s Layer: 5.75% on the Taxable Portion
- A Worked Example in Dollars
- The Viatical Exception for Serious Illness
- Sale vs. Surrender: The After-Tax Comparison
- Coordinating Taxes with Medicaid Spend-Down
- Questions for Your Tax Professional
- Frequently Asked Questions
How the Federal Rules Slice the Proceeds
IRS Revenue Ruling 2020-05, applying the post-TCJA basis rules, settled the modern framework. A settlement is taxed in three stacked tiers:
- Return of basis — no tax. Proceeds up to the total premiums you paid come back tax-free. The TCJA eliminated the old requirement to reduce basis by cost-of-insurance charges, so basis is larger — and taxes smaller — than under pre-2018 law.
- Ordinary income. Gain from basis up to the policy’s cash surrender value is taxed like wages or IRA withdrawals.
- Capital gain. Proceeds above cash surrender value are capital gain — long-term for virtually all settlement sellers, taxed at preferential federal rates.
Your policy’s cash surrender value is therefore a tax boundary, not just a price floor — the dollar where ordinary treatment ends and capital-gain treatment begins.
Virginia’s Layer: 5.75% on the Taxable Portion
Virginia’s individual income tax uses a short graduated schedule that reaches its top rate of 5.75% at a modest income level (2026 — verify the current brackets with the Virginia Department of Taxation). Virginia starts from federal adjusted gross income, so the ordinary-income and capital-gain portions of a settlement flow into Virginia taxable income; Virginia does not offer a preferential rate for capital gains, so both taxable tiers face the same state rate.
The return-of-basis tier stays tax-free for Virginia purposes just as it does federally. For planning, the arithmetic is friendly: estimate your federally taxable portion, multiply by roughly 5.75%, and you have a serviceable first guess at the Commonwealth’s share — subject, as always, to your preparer’s actual calculation.
A Worked Example in Dollars
Take a Northern Virginia retiree selling a universal life policy:
- Premiums paid over the years (basis): $50,000
- Cash surrender value: $62,000
- Settlement price: $150,000
Federal tiers: the first $50,000 returns tax-free. The next $12,000 — basis up to the $62,000 surrender value — is ordinary income. The remaining $88,000 is long-term capital gain. Virginia then taxes the $12,000 and the $88,000 at its ordinary rates, essentially 5.75% at these amounts — roughly $5,750 to the Commonwealth on $100,000 of taxable proceeds, alongside the federal bill.
Real policies rarely have tidy numbers, and basis on decades-old policies takes effort to document — request the insurer’s premium history early. Have a CPA run the actual tiers before you accept any offer.
| Portion of Proceeds | Federal Treatment (2026) | Virginia Treatment (2026) |
|---|---|---|
| Up to premium basis ($50,000 in example) | Tax-free return of basis | Tax-free |
| Basis up to cash surrender value ($12,000 in example) | Ordinary income | Taxed at Virginia rates, top 5.75% (verify) |
| Above cash surrender value ($88,000 in example) | Long-term capital gain | Taxed at Virginia rates — no state capital-gain preference |
| Viatical settlement (life expectancy under 24 months) | Generally excluded under IRC Sec. 101(g) | Generally follows the federal exclusion (verify) |
| Surrender instead of sale | Gain above basis is ordinary income | Taxed at Virginia rates |
The Viatical Exception for Serious Illness
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 proceeds from federal income tax entirely, treating the sale like an early death benefit. Chronically ill insureds may also qualify for favorable treatment when proceeds fund qualified long-term-care expenses, under additional conditions.
Because Virginia conforms to federal income definitions, amounts excluded federally are generally excluded from Virginia tax as well (verify with your preparer). Eligibility has technical requirements — the buyer typically must be an appropriately licensed provider, and the medical certification must meet the statutory standard — so raise illness-related eligibility with the settlement company and your tax professional at the very start of the process.
Sale vs. Surrender: The After-Tax Comparison
Surrendering to the insurer is taxable too: gain above basis is ordinary income. In the example above, surrender yields $62,000 of cash and $12,000 of ordinary income. The settlement yields $150,000 of cash, with the extra $88,000 taxed at capital-gain rates — the gentler federal treatment. So the incremental money a settlement adds is generally the most tax-efficient part of the deal.
The scale of that increment is the headline: the federal GAO’s market study (GAO-10-775) found settlements typically paid 10% to 35% of face value, roughly 4 to 8 times cash surrender value. Even fully taxed, a qualifying policy usually nets several times more sold than surrendered. Our guide to life settlement vs. surrender frames the full comparison; a free policy review supplies the market side of the ledger.
Coordinating Taxes with Medicaid Spend-Down
Virginia families often sell a policy as part of qualifying a parent for long-term-care Medicaid. The tax rules still apply — so sequence deliberately: complete the sale, reserve the tax owed, then spend the remaining proceeds on care and other compliant uses before the application. Because the sale occurs at fair market value, it is not a gift and does not trigger Medicaid’s five-year lookback penalties.
Virginia’s specific limits — the $2,000 countable-asset ceiling, the community spouse allowance, and the Commonwealth’s 209(b) wrinkles — are covered in our guide to Virginia’s Medicaid asset and income limits. An elder law attorney should hold the calendar for both the tax year and the application date.
Questions for Your Tax Professional
Bring these to your CPA or enrolled agent along with the offer letter and your latest policy statement:
- What is my documented basis, and will the insurer confirm it in writing?
- How does the offer split across the tax-free, ordinary, and capital-gain tiers?
- What is my combined federal-plus-Virginia liability this year — and would deferring to a lower-income year help?
- Does the insured’s health qualify the sale for Section 101(g) viatical treatment?
- Should I make an estimated payment to avoid underpayment penalties?
If you have no offer yet, get one first — a free policy review needs only the policy’s cover page and gives the tax conversation real numbers. Call (305) 209-7183, see how our process works, or browse the Education Center.
Frequently Asked Questions
Are life settlement proceeds taxable in Virginia?
Partially. Federally, proceeds up to your premium basis are tax-free, gain up to cash surrender value is ordinary income, and the excess is capital gain. Virginia taxes both taxable tiers at its ordinary rates, topping out at 5.75% as of 2026. A tax professional should confirm your specific numbers.
Does Virginia tax capital gains from a life settlement at a lower rate?
No. Virginia has no preferential capital-gains rate — the capital-gain portion of your settlement is taxed at the same ordinary rates as the rest, up to 5.75%. The capital-gain distinction still matters federally, where long-term rates are lower than ordinary rates.
What part of my settlement is completely tax-free?
The return of your basis — generally the total premiums paid over the policy’s life. Post-2017 rules no longer reduce basis by cost-of-insurance charges, which enlarged the tax-free tier for most sellers. Get a written premium history from your insurer early; reconstructing it later is harder.
Are viatical settlements taxed in Virginia?
Generally no. When the insured is certified terminally ill with a life expectancy of 24 months or less, IRC Section 101(g) typically excludes the proceeds from federal income tax, and Virginia generally follows that exclusion. The buyer licensing and physician certification requirements must be met, so confirm eligibility upfront.
Is surrendering my policy better for taxes than selling it?
Rarely. Both trigger ordinary income on gain above basis, but a settlement’s additional proceeds above cash surrender value are taxed at federal capital-gain rates — the lighter treatment. Since settlements historically pay about 4 to 8 times surrender value, the after-tax result usually favors selling a qualifying policy.
How do taxes interact with a Medicaid spend-down in Virginia?
The sale is taxable regardless of how you use the proceeds, so reserve the tax before spending down. Selling at fair market value is not a gift and creates no lookback penalty. Sequence the sale, the tax reserve, the compliant spending, and the Medicaid application with an elder law attorney.
How do I get real numbers to plan around?
Start with a free policy review — send the policy’s cover page and you receive a realistic value range at no cost or obligation. Pair that range with your insurer’s basis figure, and your CPA can estimate the full federal and Virginia tax picture before you commit to anything.
Find out what your policy is worth — free, confidential, no obligation.
A 15-minute educational review covers your eligibility, every alternative, and a realistic view of what each path would net you.
Related Reading
- Life Settlement Vs Surrender
- Cash Surrender Value Life Insurance
- Virginia Medicaid Asset Income Limits
- Life Settlement Licensing Virginia
- How It Works Policy Options
- 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.