Viatical settlement tax can be a major factor when deciding to sell a life insurance policy for cash. A viatical settlement is made when the policyholder of a life insurance policy decides to sell their policy due to chronic or terminal illness. Anyone seeking a viatical settlement is encouraged to first use a life settlement calculator to discover if their policy even qualifies.
What makes viatical settlements different from accelerated death benefits is that viatical settlements are sold to third parties opposed to being cashed out by the insurance company. Usually, the intent is to make end-of-life care expenses easier for the policyholder and their loved ones. Viatical settlements can be tax-free at the federal level. However, when it comes to New York state taxation, this is not always true.
Generally, viatical settlements are split into two categories as outlined in IRS Publication 525:
- Terminally Ill: the policyholder has been certified by a medical professional that they have 24 months or less to live
- Chronically Ill: the policyholder is no longer able to do two or more activities necessary to daily life (e.g. eating, bathing, using the toilet) and requires supervision to avoid harming oneself
New York State Matching Principle
Much of New York’s state tax code employs the matching principle. So, if an item is includable or excludable from gross income at the federal level then it’s also true of state-level income though there are exceptions. Viatical settlements largely fall under this matching principle because you will only owe New York state taxes on viatical settlements if they do not meet conditions the IRS has outlined for terminally or chronically ill individuals.
If any amount of viatical settlements was received and included in your federal adjusted gross income, they must be included in your New York adjusted gross income. If the payments were excluded due to meeting the conditions described for terminally or chronically ill policyholders, then the payments are not subject to state taxation.
So, for terminally ill policyholders, certification from a physician is required that they are expected to have 24 or fewer months to live. The viatical settlement can be received periodically or in a lump sum in a reasonable timeframe from when the policyholder has received the certification from their physician.
For chronically ill individuals, the rules are more complex.
Avoiding Viatical Settlement Tax In New York State for the Chronically Ill
To avoid both federal and New York taxation on viatical settlements for chronically ill individuals, simply having certification from a physician isn’t enough. The defining characteristic of “chronically ill” for this purpose is that the policyholder is no longer able to do at least two basic functions of daily life. This usually means a policyholder is requiring a full-time caregiver if aging in place or needing to move to a nursing home or assisted living center. End-of-life care arrangements keep rising in cost. Viatical settlements have become a common way to pay for them in order to avoid burdening loved ones.
In order to exclude viatical settlements from taxable income, the policyholder is chronically ill–not terminally ill–there are limits on how much of these payments are excludable. The limit is based on the grand total of the viatical settlement and any periodic payments from long-term care insurance contracts. The exclusion is then pegged to the actual care expenses incurred.
New York Viatical Settlement Tax Example – Chronically Ill
For example, Bill is an elderly and chronically ill New York resident who has no long-term care insurance. He arranges for a per diem viatical payment of $10,000 per month to pay for his caregiver and living expenses. Bill’s eligible care expenses total $9,000 per month. Assuming these payments and expenses have been consistent throughout 2019, Bill’s total reported viatical settlement is $120,000 and he can peg this amount to the $108,000 in qualified long-term care expenses he paid. While most of Bill’s viatical settlement will be tax-free on both federal and New York levels, he will have $12,000 in taxable income for both federal and New York state purposes.
The rules are applied similarly if Bill does have long-term care insurance where the excluded amount must be reduced by any reimbursement received from the long-term care insurance carrier. Assuming Bill’s settlement and expense amounts are the same, let’s say that his long-term care insurance reimburses him $4,000 for his expenses every month. If Bill still receives a $120,000 viatical settlement, the $48,000 reimbursement must be factored into the $108,000 that was excluded in the last example so his taxable portion is now $60,000.
When opting for a viatical settlement in New York state, it is more straightforward for terminally ill individuals to be tax-free. For chronically ill policyholders, careful attention must be paid to projected caregiving expenses as well as potential reimbursements from long-term care insurance.