Life Settlements and Taxes in 2021
Life settlements are a viable option for those looking to surrender their life insurance policies, but understanding the changing rules around taxation is essential. It’s important to remember that life settlement payments are treated as ordinary income when it comes to taxes.
When President Trump’s administration passed the TCJA, life settlements became a more attractive option. Section 13521 of the TCJA states that “in determining the basis of a life insurance contract or an annuity contract, no adjustment is made for mortality, expense, or other reasonable charges incurred under the contract.” This essentially reversed the IRS rule that said the life insurance policy seller’s basis is reduced by the cost of insurance (COI) for mortality, expense, or other reasonable charges incurred. In other words, whether a policyholder surrenders their policy to the insurer for a gain or sells it outright, the basis is calculated as the full premiums, which benefits policyholders.
Under the TCJA, settlement amounts:
- Up to cost basis (full premiums) are free of income tax.
- Above cost basis and up to cash surrender value (CSV) are taxed as ordinary income.
- Above CSV and up to the life settlement amount are taxed as capital gains.
Let’s look at this example: If a policy with a cost basis of $250,000, and a cash value of $400,000 was sold for $800,000, the total gain for the seller would be $550,000 ($800,000 sale price minus $250,000 cost basis received tax-free), $150,000 of that amount ($400,000 cash value minus $250,000 cost basis) would be taxed as ordinary income and $400,000 ($550,000 total gain minus $150,000 taxed as ordinary income) would be taxed at capital gains rates. If there is no cash value in the policy, the total amount received above cost basis is taxed at capital gains rates.
The Biden administration has stated that the president intends to repeal parts of the TCJA, which may negatively affect the life settlement and life insurance industry. Previous to TCJA, the cost of insurance inside a policy did not count as cost basis. This increased the tax. Furthermore, clients and their advisors would often not be able to obtain the COI figures from the carrier to separate them from the premium, making it difficult to calculate taxes on a life settlement transaction.
If parts of the TCJA are repealed, including the beneficial elements to taxation of surrendered or sold life insurance policies, that could lead to higher taxation and difficulty calculating cost basis. In addition, the Biden tax plan also aims to remove capital gains for anyone with an income greater than $1 million. So, for wealthier policy owners, their taxation could almost double from 20% to 39.6%. This, coupled with a proposed reduction of most of one’s cost basis, could be debilitating to the owners of life insurance with regard to their options for exiting a policy.
About Abacus Life
Abacus Life Settlements has been a leading buyer of life insurance policies in the U.S for the last 16+ years. With over 10$ billion in policy face value purchased, we have helped thousands of clients maximize the value of their life insurance. We provide white-glove services to financial advisors and policy owners. Want to learn about the true value of your Policy? Check out our Market Value Calculator to get a free estimate.
Life Settlements and Taxes in 2021 | Abacus Life
