Are Life Settlements Taxable?

If you’re considering selling your life insurance policy through a life settlement, it’s important to understand the taxation of life settlements for policyholders and investors. Life settlements can provide policyholders with more cash than their policy’s surrender value and turn a burdensome premium payment into liquid assets. Many people choose to pursue a life settlement later in life to bolster their retirement savings and reduce worries about outliving their assets.

However, before you move forward, it’s crucial to understand the federal taxes associated with life settlements. These transactions can help you meet your financial needs, but as with any significant financial decision, understanding their tax treatment is essential.

While there are multiple settlement types, each with their own potential tax ramifications, the Tax Cuts and Jobs Act (TCJA) of 2017 simplified the federal tax code for life settlements (according to the US Congress and the American Academy of Actuaries). This means you shouldn’t have to spend too much time deciphering tax codes and can more easily understand what you may owe, if anything.

In this article, we’ll explore the latest information on how life settlements are affected by federal taxes, and what you can do to minimize the tax burden of your settlement.

How Are Life Settlements Taxed?

The amount of federal taxes you’ll pay on a life settlement depends on the premiums you’ve paid into the policy and the difference between the settlement amount you receive and the policy’s cash surrender value.

• For Policyholders: The proceeds are taxable if the settlement exceeds the premiums paid into the policy. If the settlement exceeds your premiums but not the cash surrender value, it is taxed as ordinary income. The excess over both the premiums and the cash surrender value is taxed as long-term capital gains.

For more detailed information on how life settlements are taxed, you can refer to the IRS’s official guide on Publication 525, which provides comprehensive details on the taxation of income.

What Defines “Profit” in Life Settlements?

A “profit” from a life settlement is defined as the difference between the premiums paid and the cash payout received. Some of that profit is taxed as ordinary income, while other portions are taxed as capital gains, depending on how your cost basis (the amount you’ve paid in premiums) compares to the policy’s cash surrender value when it was sold.

While this might sound straightforward, it wasn’t always that simple. Thankfully, the Tax Cuts and Jobs Act (TCJA) of 2017 simplified this process for taxpayers, making the tax treatment of life settlements more transparent.

How Does TCJA Affect Life Settlement Taxation?

The TCJA significantly streamlined the taxation of life settlements. Under the TCJA, your cost basis is defined as the total premiums paid for the policy. This provides greater clarity and reduces the overall tax burden.

Example: In the past, the cost basis might have been reduced by factors such as the cost of insurance, but under the TCJA, the full premiums paid are considered the cost basis. This change offers two important benefits for policyholders:

1. It simplifies the calculation process.
2. It lowers the taxable gain, which in turn reduces the taxes owed.

For example, if you sell your policy for $58,000 and the total premiums paid were $42,000, the taxable gain is simply $58,000 – $42,000 = $16,000. That gain is then taxed based on whether it is classified as ordinary income or capital gains.

Taxation of Life Settlements for Policyholders and Investors

The taxation of life settlements for policyholders and investors is similar but has key differences. Understanding these distinctions is crucial when deciding whether to sell a life insurance policy or purchase one.

For Policyholders:

• Proceeds Taxable: If the settlement exceeds the premiums paid, the excess is subject to taxes.
• Ordinary Income vs. Capital Gains: If the excess amount is less than or equal to the cash surrender value, it’s taxed as ordinary income. Any excess beyond that is taxed as long-term capital gains.
• Viatical Settlements: If the policyholder is terminally ill, the settlement may be exempt from tax as part of a viatical settlement.

For Investors:

• Taxation on Gains: Investors are taxed on the gains they receive from selling life insurance policies, which are typically treated as long-term capital gains.
• Death Benefit: When the policyholder passes away and the investor receives the death benefit, it is generally tax-free under current tax laws.
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Are Life Settlements Taxable?

Yes, life settlement proceeds are federally taxable to the extent that you make a profit from the transaction. If the amount you receive from the settlement exceeds the premiums you’ve paid, that excess is generally subject to taxes as either ordinary income or capital gains.

Are Life Settlements Taxable on a State Level?

In addition to federal taxes, you may also be subject to state taxes on your life settlement proceeds. States have different rules regarding taxation on life settlements, and understanding your state’s tax laws is critical to predicting your total tax burden.

• States that treat capital gains as ordinary income: If your state taxes capital gains as ordinary income, you’ll likely pay your effective state tax rate on the entire taxable gain.
• States with preferential capital gains tax treatment: Some states have a lower tax rate for capital gains.  
• States with no income or capital gains tax: States like Florida, Texas, and Nevada do not tax ordinary income or capital gains, meaning your life settlement would only be subject to federal taxes.

The Difference Between Life Settlements and Viatical Settlements

It’s important to understand the difference between life settlements and viatical settlements, especially when considering taxation. A viatical settlement is typically for policyholders who are terminally ill, and the IRS does not consider viatical settlements taxable.

On the other hand, a life settlement is for individuals who are not terminally ill but still want to sell their life insurance policy. The Tax Cuts and Jobs Act (TCJA) applies specific rules for taxing life settlements but does not apply to viatical settlements.

Can I Receive a Tax-Free Life Settlement?

Many life settlements end up untaxed federally because the amount of premiums paid often exceeds the final payout value. Even when taxes do apply, it’s worth noting that a settlement is almost always the best way to receive a meaningful payout on your life insurance while still alive and to recoup some or all of the premiums you’ve paid over the years.

For example, in some cases, the proceeds from a life settlement may be entirely tax-free if the premiums paid on the policy exceed the settlement value. It’s also possible to minimize tax liability through specific planning strategies.

If you plan to pursue a life settlement with your existing life insurance, we recommend speaking with a tax professional. A tax professional will help clarify your unique situation and offer strategies for minimizing the tax impact.

How to File Taxes on a Life Settlement

Once you’ve determined how much of your life settlement is taxable, it’s important to understand the tax rates associated with those portions. Here’s how you can estimate your tax burden:

Ordinary Income Tax: The IRS taxes proceeds that exceed your policy’s cost basis (your paid premiums) as ordinary income. The rate depends on your total taxable income. For 2025, the federal income tax rate is based on a variety of factors, largely related to the amount of income made. Refer to the 2025 Federal Income Tax Brackets from the Tax Foundation to understand how much of your settlement will be taxed as ordinary income.

We suggest following this guide to determine what your tax burden will be on the portion of the settlement taxed as ordinary income. For more details, you can refer to the from the Tax Foundation.

Long-Term Capital Gains Tax: Any amount over the cash surrender value that is taxed as long-term capital gains is subject to the applicable long-term capital gains tax brackets. For 2025, long-term capital gains are generally taxed at:

• 0% for lower income levels.
• 15% for middle-income levels.
• 20% for higher income levels.

State-Specific Taxes: Some states impose their own taxes on life settlements, which could add an additional layer of complexity. For instance, some states tax life settlements as income, while others may not.

If you’re considering selling your life insurance policy, you may also want to explore the different options for selling your policy to companies that buy life insurance. Read more about it here. We also recommend consulting a tax professional to ensure accurate filing and avoid penalties from the IRS.

How to Minimize Your Tax Burden

While life settlement taxes can seem complex, there are strategies you can use to minimize your tax burden:

• Consult a Tax Professional: A tax expert can help you navigate the complex life settlement tax rules, ensuring that you pay the right amount and avoid potential penalties.
• Explore State-Specific Tax Rules: Some states may offer tax exemptions or reduced tax rates on life settlements. Make sure to research your state’s laws or consult a local tax professional.

Understanding the taxation of life settlements is crucial for making an informed decision. While life settlement proceeds are generally taxable, the amount of tax you owe depends on several factors, including the premiums paid on your policy and the settlement amount. By consulting with a tax professional and exploring alternative options, you can ensure that your life settlement meets your financial goals while minimizing the impact of taxes.

Are You Eligible for a Life Settlement?

Now that you understand how life settlements are taxed, it’s time to see if you qualify for one. Get started today by filling out our simple form or giving us a call to learn more. At Lighthouse Life, we help people turn their life insurance policy into cash that can contribute to a more comfortable retirement. Call us today and convert your outdated policy into valuable liquid assets!

Disclaimer:

Lighthouse Life created this post for informational purposes and does not provide tax advice. Please consult a tax professional to understand the specific tax implications for your situation. This article reflects information accurate as of the publication date. Please note that laws, regulations, and financial details may change over time. We recommend consulting a professional for the most current advice.