Tax Implications for a Client Selling Their Life Insurance Policy

Clock December 04, 2023


30-second summary

Selling a life insurance policy (a life settlement) can be a viable option for a client if they’re seeking liquidity, experiencing a change in financial circumstances, or just planning for their future. However, the tax implications of such a decision can significantly impact the net proceeds.

There are many variables to discuss with a client who is considering a life settlement, such as:

• Taxable gains and tax-exempt scenarios
• The impact of policy type and ownership
• Capital gains and reporting requirements
• Tax mitigation strategies

These are several crucial aspects for clients to consider and for you to discuss with them if they’re contemplating the sale of a life insurance policy.

As always, if you have questions about your specific situation, consult with a tax professional.

As a financial advisor, you want to make recommendations to clients that help them reach their long-term financial goals while minimizing their tax burden. This can include creating liquidity for a client by selling a life insurance policy. The points below will help you better grasp the tax implications of a life settlement.

Bear in mind that this information is not a substitute for consulting with a tax professional who is well-versed in the tax implications of life settlements.

Understanding Taxable Gains

The sale of a life insurance policy can generate income in the form of taxable gains. The taxable gain is generally calculated as the difference between the policy’s sales price and the premiums paid into the policy. This gain (if there is one) is subject to income tax, potentially resulting in a significant tax liability for your client.

Tax-Exempt Scenarios

Certain scenarios may offer tax exemptions when selling a life insurance policy. For instance, if your client is terminally or chronically ill, a portion or the entirety of the proceeds from the sale might be tax-free. A tax exemption could also apply if the policy qualifies as a “viatical settlement” due to their diminished life expectancy. These exemptions can provide significant relief from potential tax burdens.

Impact of Policy Type and Ownership

The type of life insurance policy and its ownership can also influence the tax implications. For example, selling a term life insurance policy often results in minimal tax consequences since it lacks a cash value component. However, permanent policies such as whole life, universal life, or variable life policies may build cash values, potentially making them subject to taxation upon sale. Ownership also matters; policies owned by individuals are treated differently from those owned by trusts or corporations.

Capital Gains and Reporting

Taxation on the sale of a life insurance policy typically falls under capital gains tax rules. The gain is categorized as either ordinary income or capital gain, depending on factors such as policy type, ownership, and duration of ownership. Reporting the sale accurately is essential to avoid potential penalties. Form 1099-R and Form 1040 Schedule D are commonly used for reporting such transactions.

Mitigation Strategies

Several strategies can help mitigate the tax implications of selling a life insurance policy.

One approach is a tax-deferred exchange, where your client exchanges their current policy for another investment property, potentially deferring the tax liability. Another option is utilizing the proceeds to purchase a new life insurance policy with a lower face amount, thus reducing the taxable gain. Charitable donations of the policy can also provide tax advantages.

Professional Guidance and Compliance

Given the complexity of tax implications, seeking professional guidance is crucial. Consulting with tax experts and legal professionals can help you and your client navigate the intricacies of selling a life insurance policy. Their insights can aid in optimizing the financial outcome, ensuring compliance with tax laws, and identifying the most advantageous strategies.

Selling a life insurance policy can offer financial flexibility for clients, but it’s essential to grasp the potential tax implications. Understanding taxable gains, exploring tax-exempt scenarios, considering policy type and ownership, evaluating capital gains and reporting requirements, employing mitigation strategies, and ensuring compliance are all integral to making an informed decision.

By carefully weighing the pros and cons and consulting tax professionals, you can help your clients navigate the complexities of selling a life insurance policy while maximizing the financial benefits and minimizing tax liabilities.