Comprehensive Guide to Viatical Taxation / Treatment

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People who have been diagnosed with a terminal illness, or are chronically sick, can choose to sell their life insurance policy for what is sometimes a surprising amount of cash. If you are in circumstances where you need to sell your policy – then you should be aware that your viatical settlement can be taxed.

It is a common misconception that viatical settlements are always exempt from taxes. That is not the truth – there are instances where your payout may be subjected to federal and state taxes.

In this article, we will go over the circumstances under which viatical settlements can be taxed, and how you can avoid being subjected to the taxes.

What is a Viatical Settlement?

A viatical settlement is meant for people suffering from terminal illnesses such as advanced-stage cancer, or chronic illness like Parkinson’s disease. It is a life settlement that can be used towards medical bills or to support end-of-life needs. This settlement takes place when a policyholder, who is struggling with a terminal or chronic sickness, sells their life insurance policy. 

Usually, this policy is sold to a third party, who pays out a sum that is above the cash surrender value of the policy but less than what the benefit will be. In return, they become the owner and beneficiary of your policy and death benefits. While the policyholder does not receive the face value of their policy, they get a certain amount of cash that can be used to take care of any medical expenses.

You might be thinking – what will the life settlement payout be if I sell my life insurance policy? There will be a number of factors affecting the value of the settlement, including how many years of age you are, your health, and your life expectancy. Your insurance coverage and life insurance worth will also affect the settlement. 

Other factors that will affect the policy are the type of life insurance you have chosen, its benefit, the premium costs, and who the issuer of the life insurance is. Permanent life insurance policies have more value than term life insurance policies. But if you have purchased a convertible term life insurance policy, then you can convert it into a permanent policy and sell it for a life settlement. 

An Overview of Viatical Settlement Taxation

Usually, viatical settlements are not taxed because the settlement payouts are considered to be an advance on the cash value of your life insurance. Since life insurance benefits are not taxable, neither are viatical settlements that come from the sale of the life insurance policy. However, there are certain exceptions where proceeds from a viatical settlement can be subjected to taxes.

The subject of taxation when it comes to viatical settlements is a complex matter that takes the policyholder as well as the purchaser of the policy into account. As long as both the parties meet the requisite conditions, the settlement will not be taxed. While both parties need to comply with the stipulations, it is the responsibility of the policyholder to make sure that the tax code is being followed. 

If you are a policyholder looking to sell it for a viatical settlement, then you need to be aware that the tax code can vary from state to state – which may even change yearly. Most states do follow the guidelines on viatical settlements put forth by the federal government, but some of them do not. So the tax cone you might get subjected to will also depend on the state you live in.

Tax-Free Viatical Settlement – Purchaser Requirements

The Internal Revenue Service imposes certain requirements on the party that purchases your life insurance policy. These requirements are in place because they do not want disreputable and malicious providers from taking advantage of you. 

If you want to sell your life insurance policy, then you need to be aware of what the requirements are and how to comply with them. As long as the provider is recognized by the Internal Revenue Service, there is no need for you or your tax advisor to worry about tax-related consequences.

To choose the best candidate, make sure that your viatical provider:

  • Has a history of purchasing life insurance policies from the chronically and terminally ill.

  • Has a license for their operation in the state where the policyholder lives. 

Requirements for Viatical Tax-Free Settlement from Life Insurance Policy

For your viatical settlement to be tax-free, there are certain requirements that you must meet:

  • You are either terminally ill or have a chronic illness. In the case of terminal illness, your life expectancy should not be more than two years. In the case of a chronic illness, you should have been diagnosed within the last 12 months by a medical professional – and your medical records should reflect that.

  • If the reason for selling your life insurance policy is a chronic illness, then you have to be unable to perform at least two activities for your settlement to be tax-free. The viatical settlement can be used towards living your best life, even if you have a chronic illness.

  • When selling your life insurance policy, you should be certain that the settlement provider is licensed in your state. If your state does not require a license, then opt for an experienced provider. You should only entertain solicitations from life settlement providers that have a good reputation.

  • There are certain requirements under the Viatical Settlements Model Act, and the provider must follow them. You can check the website of your state’s Department of Insurance to see if the provider is following the requirements.

How to Prevent Viatical Settlement Taxation

The Internal Revenue Service has certain guidelines regarding viatical settlements, and if your circumstances are not covered by the guidelines, then your settlement may  be taxable. Under the following instances, your viatical settlement can be taxed:

  • The settlement payout is used for something other than medical or healthcare expenses.

  • The life settlement company that purchased your life insurance policy is not recognized by the Internal Revenue Service as a qualified viatical settlement provider. Even if you had no idea about the provider’s legitimacy, you will still be taxed.

  • You have been diagnosed with a terminal disease, but your life expectancy is projected to be over two years. The no-tax stipulation of viatical settlement payment is subjected to a time limit. If you require long term care, then it will be better for you to purchase a life settlement policy instead – the proceeds from which will be partially taxable.

  • If the policyholder is a corporation, then the proceeds will be taxed. 

man doing taxes

Once you are aware of the circumstances where viatical settlements are taxable, you can consider the best practices that will be to your benefit:

  • Since this is a financial decision, consult with a financial advisor or a tax advisor, who can guide you through the process as well as help you avoid the circumstances where your settlement can be taxed.

  • Be completely sure whether your state requires the providers of viatical settlements to be licensed. If no license is needed, then make sure that they are a reputed provider who complies with the Viatical Settlements Model Act. You should only work with a reputed life settlement company.

  • If you choose to work with a life settlement broker instead, make sure that they are licensed work with reputed life settlement providers. 

  • If you are chronically ill, make sure that you are aware of what constitutes taxable and tax-free expenses.

  • If you are terminally ill, and your life expectancy exceeds two years, you can still sell your policy, although the tax treatment may be different.  Thinking through when to sell your policy should be a part of your end-of-life planning checklist.

The key takeaway from this is – while viatical settlements are usually not taxed, there can be instances where they might be subjected to taxes. You can consult financial advisors or tax advisors to help you choose right, but the decision about whether you should sell your life insurance policy can only be made by you.

Sometimes, selling your policy and paying a tax on it can be the perfect solution for you. While you may not receive the face value of your policy, the amount of cash from the settlement payout can be significant. 

Selling your policy for the cash surrender value can help you achieve your end-of-life planning checklist, or secure your family’s future. So reach out to us, and we will help you get an estimate on how much your life insurance policy is worth.

Don’t lose your lifelong investment. Discover your policy’s value today.