Life settlement proceeds can be taxable, but the exact amount depends on how much you have paid into the policy and what you receive from the sale.
The IRS breaks taxation into three tiers. First, any amount you receive up to what you have paid in total premiums is generally considered a return of your cost basis and is not taxed.
Second, any payout above the cost basis but below the policy’s cash surrender value is treated as ordinary income.
Third, anything you receive above the surrender value is considered capital gains.
This means the tax portion varies depending on how long you have owned the policy, how much premium you have paid, and how your specific policy was structured. State tax laws may also apply.
While tax obligations reduce the net payout, most people still receive far more from a settlement than from surrendering the policy. Because every situation is unique, it is a good idea to consult with a tax advisor to understand exactly how the settlement would affect your individual circumstances.
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