Do You Pay Taxes on a Life Settlement? Here’s What to Expect

A life settlement can unlock real cash from a policy you no longer need—but before you sell, it’s smart to understand the tax side. While every situation is unique, this guide explains how the IRS views life settlement proceeds, what portions may be taxable, and what’s often tax-free. It’s straightforward, practical, and written in plain English.

How the IRS Views Life Settlements

When you sell a life insurance policy, the IRS treats it as a capital transaction—similar to selling an asset. You’ve likely invested money into your policy through premiums, and when you sell it, part of what you receive may be considered a return of that investment, while the rest could be taxable.

The good news? Not all of your settlement payout is taxable. In fact, a portion—sometimes the majority—can be tax-free, depending on your policy history and total premiums paid.

Your Policy’s “Cost Basis” Explained

Your cost basis is the total amount you’ve paid into your policy (premiums minus any withdrawals or dividends). Think of it as your “investment” in the contract. When you sell your policy, proceeds up to your basis are tax-free.

Example: If you paid $50,000 in premiums and receive $80,000 in a life settlement, that first $50,000 isn’t taxable—it’s simply your own money being returned.

Which Portions Are Taxable (and Which Aren’t)

• Tax-free portion: Equal to your cost basis (premiums paid).
• Ordinary income: Any amount up to the policy’s cash value beyond your basis.
• Capital gain: Amount received above the policy’s cash value is treated as a long-term capital gain.

These rules were clarified in the Tax Cuts and Jobs Act of 2017, making taxation more transparent for sellers. You can confirm these guidelines under IRS Rev. Rul. 2009-13 and Rev. Rul. 2020-5.

A Simple Example in Numbers

Example: Mary sells her life insurance policy for $120,000. Over the years, she paid $60,000 in premiums and the policy’s cash surrender value was $80,000.

• First $60,000 → Tax-free (return of premiums paid)
• Next $20,000 → Ordinary income (up to cash value)
• Final $40,000 → Capital gain (amount above cash value)

In short: she keeps $60,000 tax-free, pays income tax on $20,000, and capital gains tax on $40,000. A tax advisor can calculate her exact rates based on filing status and income.

How Life Settlement Taxes Compare to Surrender

With a surrender, you receive only the cash surrender value, and any gain is taxed as ordinary income. In many cases, a life settlement provides a higher payout even after taxes, since the sale price often exceeds what the insurance company would offer.

See how they stack up in our article: Life Settlement vs. Surrender — Which Pays More?

Tips for Minimizing Your Tax Impact

• Consult a qualified tax advisor before closing your sale.
• Keep premium records—they determine your cost basis.
• Ask your provider for a preliminary breakdown of taxable vs. non-taxable proceeds.
• Compare your options—sometimes, adjusting timing or structure can reduce your tax burden.

Where to Learn More

The IRS provides detailed guidance in Rev. Rul. 2009-13 and Rev. Rul. 2020-5. You can also review practical overviews on our FAQ page or contact us directly to learn how life settlement offers are structured.

Quick FAQ

Are life settlement proceeds taxable?
Sometimes. Portions equal to your total premiums paid are tax-free; amounts beyond that can be taxed as income or capital gains.

How can I reduce taxes on a life settlement?
Keep accurate premium records, consult a tax professional, and confirm your cost basis before finalizing the sale.

Do I get a tax form after selling?
Yes. You’ll typically receive a Form 1099-LS from the buyer reporting the gross proceeds, and possibly a 1099-B showing gain/loss.