Understanding Viatical Settlement Taxation

Viatical Settlements vs. Life Settlements

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:

  • Quick review about what a viatical settlement is.
  • A viatical settlement taxation overview.
  • Purchaser requirements for a tax-free viatical settlement.
  • Requirements for tax-free viatical settlements.
  • Clarifying common myths about viatical settlements.
  • Best practices to minimize viatical settlement taxation.

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:

  • Age
  • Health 
  • Life Expectancy
  • Policy Type 
  • Policy Size
  • Premium Costs
  • Life Insurance Issuer

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. 

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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:

  • Features a history of regularly purchasing life insurance policies from terminally ill and chronically ill insureds. It wouldn’t be a relative or neighbor who decides to get licensed with the intent to buy your policy because they would not be considered qualified by the Internal Revenue Service.
  • Is licensed within the state where the insured lives. Or, in states that don’t require licensing, the provider must follow the disclosure guidelines outlined within the Viatical Settlements Model Act from the National Association of Insurance Commissioners (NAIC). Terminally ill insureds must conform to the NAIC’s reasonable payment guidelines, which specify minimum payouts for policies that support the insured’s anticipated time frame of death. The shorter the time frame of that anticipation, the more the payout increases. If the purchaser doesn’t follow these requirements, the viatical settlement could also be taxable.


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:

  • You must be terminally ill with the anticipation of living no longer than two years. Or, have a chronic illness diagnosed by a medical professional within 12 months.
  • If you are chronically ill, you need to be unable to perform two or more activities on a day-to-day basis.
  • The policy should be sold to a state-licensed life settlement provider. If licensing isn’t required by a particular state, make sure the provider is experienced and familiar with the tax code.
  • The provider must follow the requirements under the Viatical Settlements Model Act. While most viatical settlements are not taxable under federal law, you should check with your state’s Department of Insurance website to ensure you are working with a settlement provider that abides by the Viatical Settlements Model Act.

Here are some circumstances when your viatical settlement would be taxable because they do not fall under the Internal Revenue Service guidelines:

  • The insured uses the viatical settlement proceeds for something aside from healthcare expenses.
  • A policyholder sells the policy and finds out–after the fact–that the purchaser isn’t recognized by the Internal Revenue Service as a legitimate viatical settlement provider. 
  • The insured is plagued with a non-curable, terminal disease with a life span that is expected to exceed two years. In this instance, the insured could choose to purchase a life settlement instead of a viatical settlement.  The proceeds would then be partially taxable. 
  • The policyholder is a corporation. For example, your terminally ill mom’s corporate employer has a life insurance policy on her. Even if the purchase is compliant, the corporate policyholder would be taxed on the proceeds of the viatical settlement.

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:

  • Proceeds paid that amount to the total premiums would not be taxable.
  • Proceeds that exceed what was paid in total premiums would be treated as taxable, ordinary income.
  • Any excess proceeds are viewed as taxable capital gains.

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.

  • Viatical settlements are scams: This type of settlement is legal. It is a viable solution for people that are faced with end-of-life issues that are related to terminal and chronic illnesses. If you are concerned about the legitimacy of a viatical settlement offer, work with a reputable broker or company.  By shopping around to get multiple offers, you also gain greater insight into the legitimacy of your settlement.
  •  All viatical settlements are tax-free: The reason that not all viatical settlements are not tax-free is that all transactions must fall under certain exemptions. If those exemptions are not met, the gain recognized from the sale of the insurance contract will be taxed as ordinary income. That said, you should work with a state-licensed provider. If licensing is not required in your state, work with a reputable company that is familiar with viatical settlement tax laws, so you don’t become vulnerable to unforeseen tax implications.
  •  Viatical settlements are only for the rich: Viatical settlements are available to everyone–regardless of their financial circumstance or income level. Those that live within modest means can access cash for long-term care when they can no longer afford their life insurance premiums.
  • Viatical settlements are risk-free:  There are viatical settlement companies that accept private investor money. The money invested by these companies is not insured by a government agency, so investments should be treated cautiously.  Always be aware of the consequences and alternatives when signing paperwork—such as choosing to tap into your policy’s accelerated death benefit.

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:

  • Meet with a reputable tax or financial advisor at the beginning of your search. They will be able to walk you through the nuances of your state’s laws as well as the most current federal laws so you can avoid potential tax consequences.
  • Find out if viatical settlement providers in your state need to be licensed.  If the state you live in does not require licensing, then get something in writing from them that proves they are compliant with the NAIC’s Viatical Settlements Model Act.
  • If the insured is chronically ill, have a good understanding of what out-of-pocket expenses are tax-free.  And be aware of what proceeds do not qualify as those expenses so you know they will likely be taxable.
  • Before you accept a viatical settlement offer, make sure the prospective buyer is licensed if that is required in your state. If you are working with a broker, make sure they are working with reputable life settlement providers.
  • If the insured is terminally ill and exceeds the lifespan of more than two years, that means the settlement will be taxable. Knowing that, it might make sense to hold off on the viatical settlement until the insured is within that two-year window. If you do decide not to wait, understand that portions of the viatical settlement will be taxed as capital gains and the remainder will be taxed as ordinary income.

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.

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