What is a Viatical Settlement - image: man and woman talking at a table

What a Viatical Settlement is and how it works.

FEDZONE Ed Zurndorfer
In 2003, the nonprofit organization Life Happens created and coordinated “Life Insurance Awareness Month” (LIAM) designating the month of September to remind the American people about the importance of life insurance for their financial security. To help mark the month of September as LIAM, all FEDZONE columns featured during September will present life insurance issues that affect federal employees and retirees. This week’s column discusses life insurance viatical settlements including what a viatical settlement is and how it works.

A viatical settlement is an arrangement in which an individual life insurance policy owner (called the “viator”) who is terminally or chronically ill sells the life insurance policy to a purchaser at a discount (typically at 50 to 70 percent of the life insurance policy’s face value). The viator receives a cash payment. In exchange for the cash payment, the viator relinquishes the right to bequest the life insurance policy’s death benefit to a beneficiary of their choice. The viatical settlement purchaser then pays all future life insurance premiums on the life insurance policy. The purchaser becomes the sole life insurance beneficiary and cashes in the face amount of the life insurance policy when the viator dies.

What is the Purpose of a Viatical Settlement?

Viatical settlements enable terminally ill life insurance policy owners to sell their policies to investors. Investors buy the life insurance policy at a price that is 20 to 50 percent less than the policy’s face amount. The investor’s investment rate of return depends upon when the life insurance policy owner dies. The rate of return will be lower if the viator outlives his or her estimated life expectancy. Conversely, the rate of return will be greater if the viator dies sooner than expected.

For a life insurance policy owner who is terminally ill and has a life expectancy of less than two years, a viatical settlement enables the policy owner to obtain immediate cash that they can use for their care and comfort in their final days. A viatical settlement can allow terminally ill individuals to preserve their estate’s other assets such as a house which they may not want to sell before their death.

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From an investment perspective, a viatical settlement can be risky. The actual rate of investment return is unknown because it is usually impossible to know when the viator will die. For this reason, a potential investor in a viatical settlement should exercise caution and thoroughly investigate a viator’s health status before investing in a viatical settlement.

Many state insurance commissions (but not all) license the companies that buy viatical settlements to sell to investors. State insurance commissions may have information about a specific company who purchases viatical settlements in their states. The Federal Trade Commission also has information for individuals who are considering selling their life insurance policies.

Viatical Settlement Versus Life Settlement

Those individuals who are not facing an immediate health crisis (that is, they are not chronically or terminally ill) can choose to sell their life insurance policies in order to get some cash. This is typically referred to as a “life settlement.” A life settlement differs from a viatical settlement in that with a life settlement, the life insurance policyowner has a life expectancy of more than two years. In a viatical settlement, the life expectancy of the insured is two years or less.

If a life insurance policyholder is considering a life settlement, he or she is advised to consider alternative options for obtaining the needed cash. There may be a better way to utilize a life insurance policy in order to obtain needed cash. For example, if an individual owns a cash value life insurance policy, then the policyowner may be able to use the cash value as security for a short-term loan from a financial institution.

Taxation of Viatical Settlements

Most viatical settlements are not taxable. Settlement proceeds for terminally ill insureds are considered an advance of the life insurance benefit. Life insurance benefits are income tax-free. But the IRS imposes a list of conditions on tax-free viatical settlements which are discussed below. Another complication is state tax law. State tax law regarding viatical settlements is not consistent from state to state. Many states follow the federal taxation guidelines, but others do not. The following are the IRS rules regarding taxation of viatical settlements:

  • Purchaser requirements. In order for a viatical settlement to be federal income tax-free, the viatical settlement provider must: (1) Have a history of regularly purchasing life insurance policies from terminally ill and chronically ill insureds; and (2) Be licensed to purchase life insurance policies in the state where the viator lives.
  • Seller of insurance policies (the viator). Must be chronically or terminally ill life insurance policy owners with a life expectancy of less than two years. The viatical settlement is tax-free provided the proceeds from the viatical settlement are used to pay out-of-pocket medical, long-term care or custodial care expenses, even if the viator lives for more than two years. If the insured is terminally ill, with a life expectancy of less than two years, then the policy proceeds are always tax-free because the proceeds paid are considered as a life insurance “living benefit.”

Understanding potential viatical settlement tax implications is important for potential viators. There are five take aways to remember about viatical settlement taxation:  The viator is advised to:

  • always consult with an experienced tax advisor
  • confirm if the seller’s state requires viatical settlement providers to be licensed,
  • verify that a prospective buyer is licensed to buy life insurance policies via a viatical settlement,
  • understand that if the seller is terminally ill with an expected lifespan longer than two years, then the viatical settlement could be taxable, and
  • understand that if the insured is chronically ill, then he or she should have a good understanding of current and future out-of-pocket medical expenses. Any viatical settlement proceeds in excess of those expenses are likely to be taxable.

Taxation of Life Settlements

Life settlements are taxable to the extent that the life insurance owner makes a profit upon his or her selling of their life insurance policy. The challenge is that “profit” can mean different things to the IRS.

The Tax Cuts and Jobs Act of 2017 (TCJA) simplified life settlement taxation. Under TCJA, the profit of a life settlement is defined as the difference between the premiums the life insurance policy owner paid and the cash payout the policy owner received from the life insurance policy purchaser. Some of that profit is taxed as ordinary income and some of the profit is taxed as capital gain income. The difference in federal income tax rates between ordinary income and capital gain income and applied towards the profit depends on the policy owner’s cost (premiums paid) compared to the policyowner’s cash surrender value when the insurance policy is sold.

Since federal and state tax laws are complex, it is important for any individual considering a life settlement or a viatical settlement to consult with a tax professional in order to get an accurate assessment of the tax consequences involving a life settlement or a viatical settlement.

Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street - Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.

What is a Viatical Settlement - image: man and woman talking at a table

What is a Viatical Settlement?