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Tax Consequences Of A Sale Of A Life Insurance Policy As A Viatical Settlement

What Are The Tax Consequences Of A Life Settlement (Viatical Settlement) On The Federal Level?

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INCOME TAX

Proceeds from sale of a life settlement (also known as a viatical settlement) are tax free if both of the following are met:

  • The seller must be "terminally ill" or "chronically ill"
  • The proceeds must be received from a "Viatical Settlement Provider"

There is no limitation on how the proceeds may be spent by a "terminally ill" individual.  However, in order for money received by a chronically ill person to be tax free, the proceeds must be used for "costs incurred by the payee (not compensated for by insurance or otherwise) for qualified long-term care services provided for the insured for each period."  There are also provisions in the Code concerning proceeds paid periodically.

A "terminally ill" person is defined as "an individual who has been certified by a physician as having an illness or physical condition which can reasonably be expected to result in death in 24 months or less after the date of certification."

A "chronically ill" individual is defined as follows: "an individual is chronically ill if, within the previous 12 months, a licensed health care practitioner has certified that the individual meets either of the following descriptions.

  1. He or she is unable to perform at least two activities of daily living without substantial assistance from another individual for at least 90 days, due to a loss of functional capacity. Activities of daily living are eating, toileting, transferring, bathing, dressing, and continence.

  2. He or she requires substantial supervision to be protected from threats to health and safety due to severe cognitive impairment.

A "life settlement settlement provider" is defined as "any person regularly engaged in the trade or business of purchasing, or taking assignments of, life insurance contracts on the lives of terminally ill insureds" IF:

  • Such person is licensed for such purposes in the State in which the insured resides, or
  • In the case of an insured who resides in a State that does not require licenses for Life Settlement providers, such Provider meets the Disclosure Requirements and General Rules contained in the national Association of Insurance Commissioners' Viatical Settlements Model Act as well as the Standards for Evaluation of Reasonable Payments contained in the Regulations that accompany the Model Act.

TIP: If you have a life expectancy of more than two years, or for some other reason a sale is not tax free under the tax code, and you will wish to sell all or part of your life insurance policy, consider minimizing your potential tax burden by coordinating the amount of insurance you sell each year with your deductible expenses.  You can also transfer ownership of the policy prior to a sale to someone in a lower tax bracket, but then you have to take the potential of a gift tax into consideration.

ESTATE TAX

The proceeds from a sale will be subject to Federal estate tax, but only on the amount of the proceeds, if any, that remain at death.  

If you only sell part of your life insurance, whatever remains of the sale proceeds will be in your estate plus the amount of the death benefit you did not sell.


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