Life Insurance Policies: Planning Options If You No Longer Need Coverage

Life Insurance Sale or Surrender Tax Considerations

Besides providing loved ones with a source of funds for income replacement in the event of an untimely death of the family’s breadwinner(s), people buy life insurance for a variety of reasons, including

• Fund a buy-sell agreement for a business,
• Satisfy a lenders requirement when a loan was made, or
• Fund anticipated estate taxes.

Whether it was one of these needs or something else, circumstances change and sometimes people find that they no longer need, or perhaps can no longer afford, policies that were taken out several years ago. For example, a key person in a business retires and the key-person insurance is no longer needed or a business is sold, and the buy-sell life insurance is no longer needed.

As a result of no longer having a need for the life insurance, many taxpayers may decide to turn in or surrender the insurance policy.

Let’s review some of the tax issues associated with a sale or surrender of a life insurance policy.

Investment in the life insurance contract (tax basis)

Taxation of amounts received from the surrender or sale of a life insurance contract are governed by the owner’s investment in the life insurance contract. A policy owner’s investment in the contract is equal to the total amount of premiums paid for or into the contract, minus any tax-free withdrawals from the contract such as dividends or other income tax excluded withdrawals

Gain on surrender of a life insurance policy

The tax rules provide that any gain from the surrender of policy to the extent the cash surrender value plus any outstanding policy loans exceed the investment in the policy, will be subject to tax at ordinary income tax rates.

Loss from the surrender or sale of a life insurance policy

The general tax rule is that losses recognized upon the surrender or sale of life insurance policy are not deductible to the policy owner.  However, in some limited cases a taxpayer may be able to deduct the loss if it was incurred in a trade or business.

If you are in a situation where you have unneeded life insurance policies, before you allow a term life policy to lapse (or turn in a whole or universal life policy for its cash surrender value), we recommend that you consider whether it might be more beneficial to sell the policy. Known in the industry as a life settlement, selling a policy can sometimes net the policyholder a sufficient sum that is far more than a life policy’s cash surrender value or a term policy’s unearned premium.

A life settlement is the sale of an unwanted life insurance policy by the policy owner to an institutional investor for more than the cash surrender value of the policy but for less than the policies death benefit.

Income Tax Consequences of a Life Settlement

Sale of cash value life insurance policy

When a cash value life insurance policy is sold to an unrelated third-party investor, there is a taxable gain on the sale to the extent the cash received is greater that the investment in the contract. Gain to the extent of the amount of the cash surrender value of the policy over the investment in the policy will be taxed at ordinary income tax rates. Any cash received in excess of the cash surrender value of the policy will be taxed at long term capital gain rates. The gain is subject to the 3.8% net investment income tax.

Sale of term life insurance policy

If a taxpayer sells a term life insurance policy to an unrelated third party, the taxpayer has a capital gain to the extent sale proceeds are in excess of the investment in the contract. Again the gain will be subject to the 3.8% net investment income tax.

Note:  The above discussion assumes that the insured under the contract is not chronically or terminally ill. Under IRC section 101(g)(2), the gain from the sale of a policy by a chronically or terminally ill individual to a qualified viatical settlement provider are excluded from gross income.

If you have an unneeded policy, we provide advice on whether it might make sense to enter into a life settlement. Contact your Keiter Opportunity Advisor.