Whole Life Policy Sale

Should the policy owner of a whole life insurance policy sell the policy through a life settlement, the amount of the sale up to the “internal accumulation” is considered to be ordinary income. Any amount in excess of the internal accumulation is considered a long-term capital gain. It is important that this applies to cases where the policy was held by the seller for over a year prior to the sale.

“Internal accumulation” involves two other concepts: cash surrender value (CSV) and adjusted basis. We have already covered Cash Surrender Value. Adjusted basis is found by subtracting the cost of insurance (the actual amount of premiums paid to the insurer that was used to pay for the policy) prior to the sale from the gross amount of premiums that were paid.

In order to figure out the taxable income from a life settlement of whole life insurance, we must determine the internal accumulation. To calculate the internal accumulation, we must first find the adjusted basis.
  • Adjusted Basis = Total Premiums Paid - Cost of Insurance (prior to the sale)
  • Internal Build-Up = Cash Surrender Value – Adjusted Basis
  • Sale Proceeds < Internal Accumulation = Taxed as Regular Income
  • Sale Proceeds > Internal Accumulation = Taxed as Long Term Capital Gains

Example:

The policy owner of a whole life insurance policy sells the policy through a life settlement for $120,000. The cash surrender value of the policy is $42,000. The seller paid $21,000 in premiums and the cost of insurance before the sale was $18,000.

To determine the taxable income from the life settlement transaction we must determine the adjusted basis and then the internal accumulation.

  • Adjusted Basis = Total Premiums Paid – Cost of Insurance (before sale)
  • Adjusted Basis = $21,000 - $18,000
  • Adjusted Basis = $3,000
  • Internal Build-Up = Cash Surrender Value – Adjusted Basis
  • Internal Accumulation = $42,000 – $3,000
  • Internal Accumulation = $39,000

Next we determine the amount of taxable ordinary income and the amount of taxable long-term capital gain.

  • Taxable Ordinary Income = Internal Accumulation = $39,000;
  • Taxable Long Term Capital Gain = Sale Proceeds – Internal Accumulation;
  • Taxable Long Term Capital Gain = $120,000 - $39,000;
  • Taxable Long Term Capital Gain = $81,000;
Therefore, the seller will be taxed on $39,000 of ordinary income and $81,000 of long-term capital gains.