Understanding the tax implications of replacing or selling existing life insurance coverage will help shed some light on the options available to financial advisors and policy holders looking to capitalize on the hidden value in their life insurance plans. Policy holders need to know what the tax implications are for coverage payments in advance of death. They need to know whether viatical agreements will be taxed, and they need options when it comes to replacing expensive or undesirable life insurance policies with more favorable policies. Following are some ideas to help consider taxation of life insurance proceeds both as pre-payment advances for viatical purposes and in the case of life insurance settlements.

Viatical or Advance Payment Coverage

Viatical payments and accelerated payment of coverage in advance of death remain tax-exempt. Congress continues to favor the tax-exempt status of these policies and therefore, will probably remain tax free. To be sure, viatical and advanced payment plans cover medical bills and allow terminally or chronically ill policy holders with a life expectancy of two years or less to use insurance coverage now instead of later. Some states also exempt viatical settlements from taxation.

IRS 1035 Exchange Rule

Under the 1035 Exchange rule, the IRS allows policy holders a way to defer taxes. David Friedman explains in a Street Talk article that the 1035 rule allows “the cash value in an existing life insurance contract [to be transferred] into another life insurance contract without creating a taxable event at the time of the transfer. Any taxable gain in the existing life insurance contract is deferred as the new contract assumes the basis that had been established in the original contract.” While replacing expensive or unneeded life insurance policies with new ones is a financially savvy idea, there is an after-tax alternative that can meet and significantly exceed the advantages of a 1035 Exchange.

An LIS could sell in a tremendously robust secondary marketplace for proceeds as high as 200 or 300 percent of its cash surrender value (CSV). It's not uncommon for investors to purchase policies from policy owners who are 65 years old, have a life expectancy between three and 12 years, and whose policy is cost-effective to enforce. The concept is simple. Individual policy holders sell their life insurance coverage to the highest bidder. When this happens, the investor is named as the beneficiary and the seller receives a cash payment. The buyer assumes the yearly premium payments and collects the coverage proceeds when the policy is executed upon the demise of the seller.

The life insurance settlement can trigger ordinary taxable income and a capital gains tax. If the cash surrender value equals less than the premium contributions to date, the difference between the premium contributions and the settlement amount is a taxable capital gains. If however, the cash surrender value equals more than the premium contributions to date, two things happen: The difference between the premiums paid to date and the cash surrender value are taxed as ordinary income; and the difference between the cash surrender value and the settlement amount is taxed as capital gains.

Policy holders wishing to replace their existing coverage with less expensive coverage can do so more profitably in many cases than using the tax deferred portion of the IRS 1035 Exchange rule. Of course the after-tax proceeds of a life insurance settlement could be gifted to a charitable non-profit organization or a charitable trust. These basic tax implications regarding life insurance proceeds should prove useful in opening up further dialogue with financial professionals and advisors.