Accelerated Death Benefits. Life insurance policies may include a provision that permits the accelerated payment of benefits to a policyholder who suffers from a serious medical condition (such as cancer, heart or kidney failure, or AIDS) that will likely lead to his or her death within a specified time period such as 12 or 24 months. If such an option is exercised, amounts paid during the insured's lifetime are treated similarly to a policy loan; interest accrues on the amount advanced, and the policyholder still owns the policy and must continue to pay premiums. Because the amount advanced comes from the "pure" term portion of the policy, both term and cash value policies may be written with an accelerated death benefit provision. When acceleration is available under a policy, the amount that may be advanced under an accelerated benefit provision typically would be limited to a specified percentage of the death benefit (such as 50 percent of the death benefit) or a specific dollar amount (such as a $250,000 maximum benefit acceleration).
Viatical Settlements. Not to be confused with the accelerated payment of death benefits by an insurance company to its insured, a viatical settlement occurs when a policyholder suffering from a terminal or chronic medical condition sells the insurance policy (at a discount from face value) to a third-party viatical settlement company, which is in the business of buying policies under such conditions. A policyholder can check with the relevant state department of insurance to confirm that a viatical settlement company is licensed to do business. When a viatical settlement is transacted, the policyholder typically retains no further interest in the policy, and is relieved of the need to pay future premiums. The viatical settlement company takes ownership of the policy and responsibility for paying any future premiums, and it will receive the payment of benefits from the insurance company upon the death of the insured.
Life Settlements. A life settlement, like a viatical settlement, is the sale of a life insurance policy by the policyholder (the insured) for less than the face value of the policy to a third party investor. As in a viatical settlement, the investor takes ownership of the policy and responsibility for paying any related future premiums, and makes its return on investment when it receives the death benefits under the policy upon the death of the insured. The major difference between the life settlement and the viatical settlement is that the insured who is selling his or her insurance policy in a life settlement is not terminally or chronically ill. As a result, the investor is taking a greater risk that the insured will live longer - a factor that will be reflected in the pricing of the life settlement. Life settlements are typically designed for individuals who are over age 65 for whom the original reason for which the policy was purchased no longer exists. There are many companies that specialize in life settlement investments.
Tax Consequences of Accelerated Death Benefits or Viatical Settlements. If a person who is terminally or chronically ill (as defined in Section 101(g) of the tax code) receives accelerated death benefits or acquires the proceeds of a viatical settlement, the amounts received are treated as amounts paid by reason of the death of the insured. Accordingly, these amounts are exluded from taxable income under Section 101(g) of the tax code. The rationale for the exclusion is to ease the financial pressure on a person urgently needing cash to address a serious health care crisis. However, with respect to accelerated death benefits paid to a chronically ill person for long-term care, any benefit amount in excess of the IRS per diem limit and the actual costs of such long-term care is not eligible for exclusion from taxable income.
Tax Consequences of Life Settlements. If a person is not terminally or chronically ill (as defined in Section 101(g) of the tax code) at the time of the transaction, then the exclusion from taxable income does not apply. Because life settlements are basically investment transactions involving policyholders who are not terminally or chronically ill, the tax exclusion described above does not apply. Portions of the proceeds of life settlements will be taxed, either as ordinary income or capital gain income. Similarly, if a person who is not terminally or chronically ill surrenders his or her life insurance policy to the insurance company for its cash value, a portion of the proceeds from that transaction will be taxed as ordinary income.