By Leo LaGrotte – Life Settlement Advisors
Did you know you can sell all or a portion of a life insurance policy, even term insurance?
The opportunities to surrender or sell a life insurance policy represent a chance for many individuals to convert an expense into a liquid asset. But what does that mean for taxes? Here’s what you need to know about taxes on the surrender or sale of a life insurance policy.
What are the Tax Consequences of Surrendering a Life Insurance Policy?
The amount of your life insurance surrender payout that is taxed as income depends on the premiums you have paid into the policy.
The total of premiums you have paid into the policy is known as the cash basis. When you surrender the policy, the amount of the cash basis is considered a tax-free return of principal. Only the amount you receive over the cash basis will be taxed as regular income, at your top tax rate.
However, remember that for every $100,000 in coverage, only an average of $460 is received in surrender benefits. Depending on how long you’ve had the policy, you may not even break even on the cash basis in the surrender, especially when the surrender fees are between 10-30%.
Taxable Gains on Life Insurance Policies Sold in a Life Settlement
Much like with a life insurance surrender, the cash basis returned during your life settlement is tax-free. However, because life settlements return so much more value from the policy on average, the tax on the profits in the transaction is levied a little differently.
The proceeds received up to the tax basis (total premiums paid) are free of income tax. Proceeds received that are greater than the tax basis up to the amount of the cash surrender value are taxed at ordinary income rates. Luckily, there are many ways to minimize the impact of the capital gains tax, from reinvesting the funds in a retirement account, to making charitable contributions.
We find it is almost always the case that life settlements pay many times more than the cash surrender value of a policy. While this might give you pause in consideration to taxes, consulting with a financial advisor or tax professional can help you make the most of this opportunity without paying an unexpected big tax bill.