Life Settlements and Taxes: An Overview

The tax implications of reaching a life settlement on your personal life insurance policy are varied. It's important to do the research and speak with professionals before making a final decision.

For many people, a life settlement can be a way out of extreme financial difficulty. By selling their existing life insurance policy to an outside company, they can receive money instantly - money they can use to save their home, get out of major debt or pay for expensive medical treatments.

However, many people don't consider the unique tax burdens that come from life settlements. Failing to understand how state and federal tax laws work can cause major headaches for people in the long run, perhaps even putting them back into the same kind of financial hardship they had looked to avoid with their life settlement.

One of the advantages of a life insurance policy is that its beneficiaries can receive the benefits free of any state or federal taxes. However, if the policy is sold to a third-party, several things change. According to the Web site The Complete Lawyer, one significant change is that life settlement companies who purchase the policy from the previous policyholder now have to pay income tax on the difference between the face value of the policy and the sum of the purchase price and premiums paid.

There are several tax issues for a person collecting a senior life settlement to consider as well. For example, at the highest tax level, any money earned in a life settlement above the cash surrender value of the policy is considered to be capital gains and is expected to be taxed as such. So if a person's policy had a cash surrender value of $200,000 but they received a lump sum payment of $500,000 from a life settlement company, they should expect to pay capital gains taxes on $300,000 of their profit. But at the lowest tax level, a person might not be responsible for any income or capital gain taxes. This is why it's important to consult with a tax specialist along with your life settlement company before making any final decision on the proper course of action.

Malcolm Kinser is a writer specializing in life insurance policies and tactics. His work has been featured in print and online publications. He currently lives in Bloomington, Indiana.