Trying to interpret various tax codes isn’t an easy task for most people. This is especially true with a life settlement tax. Several changes by the IRS even further complicates matters. Fortunately, the latest update is designed to simplify the entire process of working with life settlement companies.
Life Settlement Tax Treatment
Many people often ask, “Do you have to pay taxes on life insurance settlements?” The simple answer is yes, as a life settlement is taxable to the amount of profit. However, one of the tricky aspects of a life settlement tax is that the “profit” can mean various things, according to the IRS. For example, many seniors chose not to sell their life insurance policies before 2018 due to the law’s vagueness. Instead, these seniors left money on the table by letting their life insurance lapse.
Changes to Taxes on Life Insurance Settlement
The Tax Cuts and Jobs Act (TCJA) of 2017 were specifically designed to simplify the taxation of life settlement funds. Now, the profit for a life settlement is simply defined as the difference in the premiums you paid and the cash payout from the sale. Depending on the details, some of the profit is taxed as capital gains or ordinary income.
The TCJA was eventually signed into law in December of 2017, as most of it went into effect in the following month. Policy surrenders and whole life settlements now use total premiums paid for the cost basis on the transaction. This benefits the policyholder in two ways, as it simplifies the calculations while also lowering the life settlement tax.
How are Life Settlements Taxed?
The TCJA retained the three-tier tax structure, as sale proceeds up to the cost basis aren’t taxable. However, sale proceeds higher than the cost basis and reaching the policy cash surrender value are taxable as ordinary income. Any additional sale proceeds are taxed under long-term capital gains. The most significant difference is that now policy owners do not have to decrease their life cost based on the cost of insurance.
Life Settlement Tax Treatment for Each State
Depending on your location, you may need to pay state taxes on the transaction. The amount you owe is dependent on the ordinary income and capital gains tax for your state. Typically, there are three different scenarios. Your state will tax capital gains as regular income, your state will offer preferential tax treatment on capital gains, or your state doesn’t apply any income or capital gain taxes.
Currently, nine different states offer specialized tax treatment for capital gains, including Arkansas, Arizona, Hawaii, New Mexico, Montana, North Dakota, South Carolina, Wisconsin, and Vermont. Reaching out to a tax professional is always a good idea to get a better understanding of your taxes for life settlement funds, as some states will deduct a portion from your capital gains from the state’s return. In contrast, others will define a lower rate for capital gains.
States Without an Income Tax
Nine states do not tax capital gains or ordinary income, as you won’t have to worry about making any state tax payments for your life settlement. These nine states are Alaska, Florida, New Hampshire, Nevada, South Dakota, Tennessee, Texas, Wyoming, and Washington. In other words, your tax bill on your life settlement funds is limited to charges from the federal government.
Closing Thoughts
Understanding the process of working with life settlement companies isn’t always straightforward. “Do you pay taxes on a life insurance settlement?” is an all too common question for many people. Knowing how life settlements are taxed requires some additional research, as the process for taxing life settlement funds is different for each state. However, learning about taxes on life insurance settlements and the various laws related to life settlement companies is well worth your time in helping you receive all of the money you deserve.
