Money Fox Life Settlement Taxes: How Proceeds Are Taxed
Part of the money may be tax-free, part taxed as ordinary income, and part taxed as capital gain. Here is the basic math.
- Layer 1
- Proceeds up to your basis, generally the premiums you paid, are usually not taxed
- Layer 2
- From your basis up to the cash surrender value: generally ordinary income
- Layer 3
- Above the cash surrender value: generally capital gain
- Special cases
- Terminal or chronic illness can change the answer
- Get help
- Ask a tax professional to check your basis and your numbers
If you sell a life insurance policy in a life settlement, the money you receive may be taxable. Not all of it, and not all at the same rate. The IRS has said that proceeds are generally taxed in layers, and the layers decide your bill. This guide explains the basic idea with an example. It’s general information, because the right answer depends on your policy and your situation.
The short answer
IRS guidance, starting with Revenue Ruling 2009-13 and updated for later changes in tax law, generally splits the proceeds of a sale into three layers:
- Up to your basis. Your basis is generally the premiums you’ve paid. This portion is usually a return of your own money and isn’t taxed.
- From your basis up to the policy’s cash surrender value. This portion is generally taxed as ordinary income.
- Above the cash surrender value. This portion is generally taxed as capital gain.
A worked example
This is an illustration with made-up numbers. It’s simplified, and it isn’t tax advice.
- You paid $40,000 in premiums over the years, so your basis is about $40,000.
- The policy’s cash surrender value is $52,000.
- You sell it for $100,000.
| Layer | Amount | How it’s generally taxed |
|---|---|---|
| Up to basis | $40,000 | Not taxed |
| Basis to cash surrender value ($52,000 minus $40,000) | $12,000 | Ordinary income |
| Above cash surrender value ($100,000 minus $52,000) | $48,000 | Capital gain |
If your federal rate on ordinary income were an example 22%, and your rate on long-term capital gains were an example 15%:
- Tax on the $12,000 ordinary layer: about $2,640
- Tax on the $48,000 capital gain layer: about $7,200
- Total federal tax: about $9,840
- That leaves about $90,160 of the $100,000, before fees and any state tax.
Compare surrendering the same policy for its $52,000 cash surrender value. The $12,000 above basis would be ordinary income, with about $2,640 of tax in this example, leaving about $49,360.
Your actual rates depend on your income, your filing status and how long you owned the policy. State taxes may also apply.
Things that can change the math
- Your basis. It may be different from the total of your premiums if you’ve taken withdrawals or received dividends. Confirm it with your records.
- Policy loans. An outstanding loan can create additional taxable income in a sale or surrender.
- Fees. Broker or other fees may reduce your amount realized. How they’re treated for tax is a question for a tax professional.
- How long you’ve held the policy. Capital gain rates can depend on the holding period.
- State taxes. States treat these proceeds differently.
- Illness. If the insured is terminally or chronically ill, special rules can apply.
Before you sell
- Ask each buyer or broker for an estimate of the amount you’d receive and what they’ll report.
- Gather your premium records and policy statements.
- Ask a tax professional to run the numbers for your situation, so you compare offers after tax, not before.
- Compare the sale to your other options. See what to do with a policy you can’t afford and how life settlements work.
This article is for general information only and isn’t tax, legal or financial advice. Tax rules change and depend on your situation. Examples use made-up numbers. Check with a tax professional or the IRS.
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Frequently asked questions
How do I figure out my basis?
Your basis is generally the total premiums you've paid, adjusted for certain amounts you've already received tax-free, such as some withdrawals or dividends. Your insurer's annual statements and premium records can help. A tax professional can confirm the number, because the details matter.
Is a life settlement taxed differently from surrendering the policy?
Yes. Under IRS guidance, surrendering a policy generally produces ordinary income equal to the cash surrender value minus your basis. A sale can produce a layer of capital gain on the amount above the cash surrender value. The details depend on the policy and your facts.
What if I'm terminally or chronically ill?
Special federal rules can make payments tax-free in some cases, for example when a doctor certifies that the insured is terminally ill under the law's definition. The rules are specific and the conditions matter, so ask a tax professional before you assume anything.
Will I get a tax form?
You may receive tax reporting from the buyer or the insurer, and the transaction can be reported to the IRS. Keep your own records of premiums paid, the sale price and any fees, so you can calculate the tax correctly.
Keep reading
Life Settlements: How Selling a Life Insurance Policy Works
You can sometimes sell a life insurance policy for more than its cash surrender value. Here is how it works and what you give up.
Life Insurance You Can't Afford: Your Options Besides Lapsing
Letting a policy lapse should be the last resort, not the first. Here are the options for a policy you can't afford or no longer need.
Selling a Life Insurance Policy: Brokers, Providers and Fees
Who you sell through changes how many offers you see and how much you keep. Here is what to ask and what to watch for.
Published November 10, 2026. This article is for general information and isn't financial, legal or tax advice. Terms vary by lender and state. We may be compensated by companies featured on this site. See our advertiser disclosure.