Will You Pay Taxes When Selling Your Life Insurance Policy?
Wednesday, April 14, 2021
Section: Policy Holders

If you’ve recently received a life insurance settlement or are planning to in the near future, you may be wondering how taxes may impact your proceeds, if they do at all. With the intricacies surrounding U.S. tax law, understanding how taxes and life settlements are related is incredibly important. In this blog, we will teach you everything you need to know about how you may be affected as a beneficiary of a life insurance settlement. 


Breakdown of Taxes and Settlements

According to the Internal Revenue Service, life insurance settlements and other life insurance proceeds are not included in your taxable income and do not have to be reported. However, there are a few situations in which there are exceptions. Consider these scenarios in which you may be required to pay taxes on your settlement.

Income & Capital Gains Taxes 

Interest Income

While life insurance proceeds and settlements are not directly taxed by the IRS, any interest income received will be. If funds for a life settlement are held for a specific amount of time and interest income is accumulated, the beneficiary will owe taxes on the interest accrued. For example, a million-dollar policy that is held for a year before payout with a 15% interest rate, the beneficiary will need to pay taxes on the $150,000 growth - not the full $1,150,000 payout. 

Estate & Inheritance Taxes 

Instead of naming an individual as their beneficiary, many life insurance policy holders may have the proceeds of their policy payable to their estate. However, this is quite a costly mistake. Naming an estate as a beneficiary will inevitably increase the estate's value, leaving it subject to costly estate taxes. Section 2042 of the Internal Revenue Code states that life insurance proceeds will be included in your gross estate value if it is payable to your estate or named to a beneficiary who possessed any incidents of ownership on the policy.

How Does This Affect Policyholders?

Taxes will significantly cut into the amount you receive from a life settlement. Thanks to the 2017 Tax Cuts and Jobs Act, many estates are now exempt from federal taxes. Those that are not exempt have their estate taxes capped at 40%. Luckily, there are a few ways to avoid taxation if you’re looking towards obtaining a life settlement.

Transferring Ownership

Transferring ownership is fairly straightforward. If a life insurance policy has its proceeds currently payable to an estate, transferring ownership to an individual will shield these funds from hefty taxation. If you choose to take this route, there are a few things to consider:

  1. It is important to choose an adult you trust in to be the new policy owner. Once decided, call your insurance company and complete the necessary documentation in order to successfully transfer ownership. This new owner will then be responsible for all premium payments.

  2. You will give up all rights to make policy changes in the future, unless the new owner is a family member or child. However, ownership transfer is irrevocable.

  3. For tax purposes, you will want to keep written confirmation of this transfer from your insurance company.

Life Insurance Trusts

You may also utilize a life insurance trust in order to avoid taxation on proceeds. However, you cannot be the trustee of the trust and cannot revoke the trust in the event you may have a change of heart. As you will no longer be considered the owner, proceeds will not be taxed under your estate. As opposed to transferring ownership, a life insurance trust will allow you to retain legal control over your policy.
Navigating the laws and regulations associated with life settlements can be difficult for most consumers. That’s why LISA is here to help. Stay up to date with our blog to stay current with all things life insurance and settlements.