Viatical Settlement Taxation

A viatical settlement is a financial transaction in which a terminally or chronically ill person sells their life insurance policy to a third party for a lump-sum payout they can use while still alive. Given the requirement for a terminal or chronic diagnosis, choosing a viatical settlement is a sensitive and personal decision that warrants careful consideration of all the consequences, including tax implications.

The IRS excludes viatical settlements from federal income taxation. They are not considered capital gains but a pre-payment of the policy’s death benefit, meaning your lump-sum payment is not subject to federal tax.

Most states have regulations in place regarding viatical settlements, however, and tax details can vary from state to state. It is important to discuss any state-based implications with a tax specialist.

The seller in a viatical settlement is called the viator. If the viator is terminally ill, meaning with a life expectancy of 24 months or less, the settlement payout is not taxable since it is part of the death benefit instead of a capital gain.

A viator might be chronically ill, which can have different tax implications. A chronically ill viator cannot perform at least two functions of daily living — like eating, bathing or dressing — without help. Monies used to pay for the viator’s care are generally not taxable, but if the lump-sum payment is used for other reasons there is a limit on how much is excludable tax-free per day.

In addition, most states have regulatory requirements for buyers of life insurance policies designed to protect viators. If the buyer does not meet those requirements, the viator may face tax consequences. Therefore, it’s important to have a thorough tax discussion with the viatical settlement company you choose.