Tax Treatment Considerations for Sale of Your Clients’ Life Insurance Policies

Financial advisors in 2024 are called upon to wear a number of hats for their clients, particularly those who are in retirement. Some of those hats involve the softer skills of walking through life with clients and helping them navigate the unpredictability of financial markets, while other hats involve the technical skills of asset allocation and safe withdrawal strategies.

One key aspect of these technical skills is the requirement that financial advisors are up-to-date on tax planning considerations so they are able to guide their clients into tactics that preserve as much of their cash as possible. Within the past few years, some of the key principles regarding the tax treatment of one of your client’s most valuable assets have changed — and it’s important that advisors are familiar with these changes to best serve their client's financial interests.

The 2020 IRS Shift

The Internal Revenue Service issued an important revenue ruling in 2020 that should be understood by all financial advisors with clients who own life insurance policies. IRS Ruling 2020-5 updated the agency’s official position regarding how much income an individual must recognize upon the sale of a life insurance policy contract.

This ruling was needed because the previous IRS rule (2009-13) had been impacted by changes to the federal tax law in the landmark Tax Cuts and Jobs Act of 2017, the largest overhaul of the federal tax code in three decades. The heart of the issue is related to the tax treatment of the “cost basis” for a life insurance policy that is eventually sold by the taxpayer. The previous IRS position regarding the cost basis of a life insurance contract did not fully account for the cost of insurance (COI). This meant a complicated process for determining the true adjusted cost basis when considering the sale of a policy.

This required a complicated process in which anyone interested in selling their policy in a life settlement was forced to subtract the COI from total premiums paid to determine an adjusted cost basis — something especially difficult to do for policies that were decades old. That’s because life insurance carriers were often unable or unwilling to verify past COI charges as required by the IRS.

Fortunately for American consumers, the Tax Cuts and Jobs Act amended Sec. 1016(a)(1)(B) of the federal tax code to mandate that the basis of a life insurance contract does not have to be adjusted for the expired COI. This important legislative change simplifies the process and means more favorable treatment for those selling life insurance policies.

Understanding Cost Basis and Taxable Gain

What Advisors Need to Know: In a nutshell, the IRS guidance reaffirmed that “total premiums paid” forms the cost basis for a life insurance contract and clarified that any gain realized by the sale of a policy must be recognized as taxable income and treated as a capital gain.

For example, let's say:

1. Your client sells a life insurance policy for $100,000.
2. They paid a total of $40,000 in premiums on that policy.
3. They now have a taxable gain of $60,000.
4. The Cash Surrender Value (CSV) on that policy was $50,000.
5. $10,000 of the gain (#3-#2) is taxable at the client’s income tax rate.
6. $50,000 of the gain (#3-#5) is taxable as a long-term capital gain.

According to The Tax Adviser’s recap of IRS Revenue Rule 2020-5, the new IRS guidance actually summarizes three unique situations involving taxpayers who sell their life insurance policies under varying circumstances. Rule 2020-5 makes it clear how each of those unique scenarios will be treated under the new tax regime, laying out specific directions on what the agency will view as ordinary income, long-term capital gains, or long-term capital losses. This clarity is valuable for financial advisors.

This new revenue ruling provides the official guidance that allows you to confidently advise your clients about the tax implications of selling their life insurance policies on the secondary market. While simplified, it's still wise to consult with a tax professional regarding your client's specific situation.

Selling a Policy: Your Client's Options

How Does Your Client Sell a Policy? The more favorable tax treatment of proceeds from the sale of life insurance policies may encourage some financial advisors to revisit their clients’ life insurance policies and make sure they are serving their intended strategic purpose within their portfolios. If you identify a client who owns a life insurance policy they no longer need or can afford, for whatever reason, you need to be aware of their options for selling that asset.

A life settlement is a proven strategy for generating cash from an unwanted or unaffordable life insurance policy. In a life settlement transaction, a senior sells his or her life insurance policy to a licensed third-party entity for a cash payment. The entity then takes over the premiums on the policy and collects the death benefit when the insured passes away. The funds received by consumers can be used in any manner they choose. Life settlements can be a valuable option for seniors seeking liquidity.

Life settlement transactions are highly regulated, with laws governing transactions in the overwhelming majority of states, covering approximately 90% of the US population. The life settlement industry has experienced continued annual growth as more seniors become aware of the option to sell their unneeded or unwanted life insurance policies.

Next Step

The best way to ensure that a retiree is receiving a fair market price for his life insurance policy is to work with an experienced life settlement broker, such as Welcome Funds, who can help you evaluate the policy in the context of the current IRS tax treatment considerations. A licensed life settlement broker is obligated, per applicable law, to act in your client’s best interests throughout the transactional process. Welcome Funds can provide a no-cost policy appraisal and discuss options with your clients.

For more information on Welcome Funds, Inc., life settlements, or to receive a free, no-obligation life insurance policy appraisal, please call 1-877-227-4484 or visit www.welcomefunds.com.