Selling your life insurance policy through a life settlement gives you a large one-time influx of cash, and anytime you receive a windfall like this you should be aware of the tax consequences. If you go through with a life settlement, use this guide to how your proceeds will be taxed.
The Taxes Are Multi-Tiered
As far as your taxes are concerned, a life settlement effectively changes the policy from an insurance product to an investment. Although the policy itself remains unchanged, you're liquidating it for its value - just as you would any other investment.
As a result, the proceeds you receive will be taxed just as if you sold any other investment. The money will be broken into three tiers, and each tier will be taxed differently. The three tiers are your tax basis, the policy's cash surrender value, and any additional proceeds you receive.
The Tax Basis Is Untaxed
An investment's tax basis is how much the investment cost you to purchase, and this is untaxed when the investment is liquidated. This portion of an investment's sale is money that you put in and doesn't represent any additional earnings or growth generated by the investment. You simply are getting your money back, so the government doesn't take any of this.
When an investment is a life insurance policy, the tax basis is the premiums you paid over the course of the policy. Since this is money you paid to purchase and maintain the policy, you're entitled to recoup it tax-free.
As an example, assume you had a life insurance policy that you maintained for 15 years and paid $8,000 per year for in premiums. You would've paid $120,000 in premiums, which would be your tax basis. The first $120,000 you received from any sale wouldn't be taxed.
The Cash Surrender Value Is Taxed as Income
The cash surrender value is how much you could receive from your insurance company if you closed the policy with them. This amount represents your premiums plus any growth that the policy has generated, and it's normally higher than the premiums you paid.
The difference between the tax basis and cash surrender value is taxed at your income tax rate. Depending on your tax bracket, this might be anywhere from
10 to 37
percent for your federal taxes. State income taxes vary, but you would have to pay any taxes that your state requires as well.
In the example, also assume your policy had a cash surrender value of $250,000. After subtracting the $120,000 in premiums paid, the remainder would be $130,000. The $130,000 would be taxed at your income tax rate for the year in which you process the life settlement.
Depending on your income level, the taxes assessed on this portion of your received funds can be significant. In the given scenario, the income tax rate for the $130,000 would be at least 24 percent (which is the rate for income between $84,201 and $160,725. If you had additional income, it could push your taxes to a still higher rate.
The Additional Proceeds Are Taxed as Long-Term Capital Gains
Whatever additional funds you receive from your life settlement will be taxed as long-term capital gains. These rates are lower than income tax rates. The federal long-term capital gains rate is 0, 15, or 20 percent depending on what income you have in a year, and some states also have long-term capital gains taxes.
In the given example, anything above $250,000 would be taxed according to your long-term capital gains rate for the year.
Even with the taxes, life settlements still leave a lot of money in your bank account. To explore what a life settlement could provide you with,
contact
Habersham Funding LLC.
