To sell or surrender?
by Lingke Wang
Mr. Wang is affiliated with Ovid, a settlements consultant firm. He blogs regularly on various aspects of the settlement process, and shares a recent post that, while aimed at a retail audience, provides useful information on how settlements can work within a client’s overall retirement plan. Visit ovidlife.comOur ongoing series on the ‘mechanics of the advisory portfolio’ looks at new and emerging strategies being employed in retirement planning today.
The sale of a life insurance policy is a taxable event and is treated based on the guidelines set out in Revenue Ruling 2009-13.
We provide a general explanation of the process here, but you should seek advice from you tax advisor to help with your specific situation.
To illustrate the tax treatment, let’s examine the IRS ruling’s example.
Here is a summary of the facts provided by the example:
- Cash surrender value of $78,000
- Total premiums paid of $64,000
- Cost of insurance of $10,000
- The policy has been owned for 8 years, has had no withdrawals, and has had no loans
- The individual is not terminally or chronically ill
- The policy is sold for $80,000 in a life settlement transaction
Internal Profits
In the example, the IRS states that the taxable amount is the proceeds minus the premiums paid above the cost of insurance. In this example:
- Life Settlement Proceeds: $80,000
- Paid Premiums above the Cost of Insurance: $54,000 ($64K – $10K)
- Gains (taxable income): $26,000
Of the taxable income, the portion that is the policy’s internal “profit” (surrender value less premiums paid) is taxed as ordinary income.
The remaining is treated as a gain on property interest and is taxed at capital gains rate. In this example, the internal “profit” is $78,000 – $64,000 = $14,000. Therefore $14,000 is taxed as ordinary income, and $12,000 is taxed as long term capital gains.
To determine whether it would be better from an economic standpoint for the policy owner to sell or surrender the life insurance policy, the net proceeds that remain from a life settlement after taxes must be compared to the after-tax proceeds an individual would obtain from surrendering the policy.
Again this example only covers the basics of how taxation for life settlements work. You should contact a tax advisor for advice when evaluating your specific case.
