The statutory increase of the federal estate/gift transfer tax threshold to over $5.6 million in value per individual (over $11 million for a married couple), the portability of unused exemption amounts on the death of the first spouse to die coupled with the current $14,000 annual gift tax exclusion has lessened reliance on the use of life insurance policies to pay estate tax. But, as a recent NY Times article explains clients contemplating the future of no longer needed policies should consider the possibility of a “viatical settlement” – the sale of the policy during the insured’s lifetime for cash – rather than its surrender.
Unlike the gratuitous inheritance of policy proceeds, sales of policies by an owner whose medical condition is not terminal (or in certain cases, chronic) creates taxable income which is taxed as ordinary income, capital gain or a combination of both depending upon the cash value of the policy, the components of the premium payments, the cost of insurance, whether the increase is cash value is a result of untaxed income and the age of the policy. For the third party buyer of such an investment, the net proceeds of the policy are always taxable income. Because life insurance is a state regulated product, the permissibility of such sales and their investment character (is it a security?) varies from state to state.