Permanent life insurance often offers its owner a number of benefits, such as access to cash value while the insured is still alive. Because life insurance contracts can be assigned to another person, some investors purchase life insurance policies from the elderly and terminally ill. Investors in life settlement policies purchase and take over the premium payments for life insurance policies to receive the death benefit when the insured dies.
Tax Status of Death Benefit
When the person insured by the life insurance contract dies, the insurance company will pay the death benefit to the beneficiary. Because the investors of life settlement policies have no other relationship with the insured, and would not otherwise see any detriment to their finances upon the insured’s death, the normal tax-exempt status of death benefits doesn’t apply.
The investor will be taxed on the death benefit. However, because the investor paid for the settlement using money that had already been taxed, she can exclude the original purchase price as well as any premiums paid in from the taxable amount. For example, a person who purchases a contract for $15,000, pays $5,000 in premiums and receives $100,000 after the death of the insured would make $80,000 on the investment.
Internal Revenue Service rulings treat the income made by life settlement investors after receiving the contract’s death benefit as ordinary income, rather than capital gains. While this ruling makes filing taxes simpler for the recipient of life settlement income, the gains are taxed at a higher rate than most investment vehicles. Keep this distinction in mind when comparing yields.
Resale of Life Settlements
Should the investor of a life settlement policy sell her policy to another investor before the insured dies, then the income from that transaction is treated as capital gains. The investor’s tax basis in the policy is the sum of the original purchase price plus all paid premiums, without regard to cost of insurance. Taxable income is the gain over purchase price and premiums paid into the policy.
Investors in life settlement policies are not guaranteed a profit from their investments. People, even the terminally ill, can live longer than anticipated, which means the investments require larger premium outlays to pay off. Similarly, insurance companies can go out of business or the original contracts could have been sold fraudulently, in which case the insurance company is not obligated to pay. Further, because the policies must be maintained, investors must put more than the original purchase price at risk.
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