Are you considering a viatical settlement for a loved one? If so, you may be wondering if you are required to pay taxes on your payout. Many people believe that all viatical settlement proceeds are tax exempt. Unfortunately, that’s not always true. There are instances when viatical settlement payouts are indeed subject to state and federal taxes.
In this article, we’ll explain the federal guidelines on viatical settlements, so you know for sure if you meet tax-free requirements. Here’s what we’ll cover:
What’s a Viatical Settlement?
Not 100 percent sure what a viatical settlement is? Let’s do a quick review. A viatical settlement is a life settlement that is tailored specifically for people with terminal or chronic illnesses—like advanced-stage cancer or Parkinson’s disease. You can use the funds for medical bills or enhance end-of-life comfort. This settlement occurs when the terminally or chronically ill policyholder sells their life insurance policy to a third party. The worth prescribed is usually above the cash surrender value but smaller than the benefit. Some of the factors that can affect the value of your policy include:
Viatical Settlement Taxation Overview
For the most part, viatical settlements aren’t taxable. Settlement proceeds are deemed as an advance of life insurance benefits for the terminally or chronically ill. Since life insurance benefits are tax-free, the same goes for viatical settlements.
There are however exceptions to this rule. The interior Revenue Service features a list of conditions on tax-free viatical settlements. What makes it complex is that a number of these conditions are directed towards the policyholder while other conditions are targeted towards the purchaser of your life insurance policy. Both you, as well as the purchaser, must meet these conditions for your viatical settlement to be tax-free. What’s more, it is your responsibility to make sure your purchaser is compliant with the tax code since you will be responsible if taxed are owed.
In addition to that complication, state-by-state tax laws are not consistent and can change yearly. Most of the states follow the federal taxation guidelines on vatical settlements, but some don’t. The bottom line is each viatical settlement tax treatment can vary depending upon the small print of your transaction.
At the federal level, most viatical settlement payouts are treated similarly to a benefit. For the most part, this means the cash you receive will be tax-free. You will want to meet all the requirements within the federal tax code, which is the piece of legislation specifically for viatical settlement taxation. You must consult with a tax or financial advisor instead of trying to figure out the implications of the tax code on your own. If you ignore tax liability, you may incur Internal Revenue Service penalties for either under-withholding or overestimating the transaction’s net proceeds. We will review the general requirement to maintain a tax-free viatical settlement, below.
Purchaser Requirements for a Tax-Free Viatical Settlement
Even though you will be the one that is responsible for paying the tax bill, the Internal Revenue Service does impose requirements on the purchaser of your life insurance policy. The reason for this is because they want to protect the policyholder from disreputable providers. It is up to you–and your tax advisor–to be aware of compliance requirements so that you prevent possible tax consequences. This can be avoided if the policy purchaser is recognized as a viatical settlement provider by the Internal Revenue Service. A qualified viatical provider:
Viatical Settlement Tax-Free Requirements
As a policyholder, you must be terminally ill with the anticipation that you will live no more than two years. Or you must be diagnosed with a chronic condition by a medical professional within 12 months of when you start to convert your life insurance policy to a viatical settlement.
Requirements for chronically ill policyholders differ from those that are terminally ill. For one, the chronically ill insured’s life expectancy is hard to determine. Because of that reason, the viatical settlement requirements are defined by the insured’s inability to perform two are more daily functions. They include difficulty moving around, eating, and grooming. These are called ADLs (Activities of Daily Living). A viatical settlement won’t be taxable if the proceeds are used towards out-of-pocket expenses such as assisted daily care, uncovered medical bills, etc. Put simply, they are expenses not covered by basic health and long-term insurance.
Just to recap here are the requirements to ensure your viatical settlement will be tax-free:
Here are some circumstances when your viatical settlement would be taxable because they do not fall under the Internal Revenue Service guidelines:
Once your eligibility has been determined, the next step is to sell your life insurance policy to a licensed settlement provider in your state. If your state does not require providers to be licensed, the provider should be an experienced life insurance purchaser that abides by the requirements of the Viatical Settlement Model Act. This means the provider is required to pay a particular amount of the policy’s benefit that supports the policyholder’s anticipation and meets operating standards. The shorter the anticipation, the more extra money the provider must offer for the policy.
So, what’s the next step when you realize you don’t meet tax-free viatical settlement guidelines? It is best to consult with a reputable tax advisor who can walk you through the most current laws and pinpoint how you can minimize tax liability. If the Internal Revenue Service views your transactions more in line with a life settlement than a viatical settlement, you would be taxed this way:
Clarifying Common Viatical Settlement Myths
As the life settlement industry continues to grow, the internet has become flooded with misleading information. Unfortunately, separating fact from fiction can be challenging. Here are some of the most common myths and misconceptions out there specifically when it comes to viatical settlements.
Best Practices to Prevent Viatical Settlement Taxation
Once you understand why a viatical settlement is taxable, you will have a clearer picture of how it can benefit you. Here are some best practices to consider while going through the process of converting your life insurance policy into a viatical settlement:
The bottom line? Even if some proceeds are taxable, selling your life insurance may still be the best option for a loved one’s end-of-life comfort and your own family’s future security. Only you can make that decision but know there are tax or financial advisors available to help you make the right choice.