Life Settlement

A viatical settlement involves:

1. A.A tax on the death benefitNo tax is being assessed here. The transaction is a sale of the contract by the insured in exchange for cash during life.
2. B.A terminally ill insured selling the policy for cashCorrect - viatical = sale by an ill insured.
3. C.A dividend optionA dividend option directs surplus returned on a participating policy. It leaves ownership exactly where it was, while this transaction hands the policy to a buyer.
4. D.The insurer cancelling coverageThe insurer is not terminating anything. The policy remains in force with premiums continuing; what changes is who owns it and who will ultimately collect.

Why: In a viatical settlement, a terminally or chronically ill insured sells their policy to a third party for immediate cash.

Age 78 and no longer needing coverage, Wilhelmina Strachan-Vogel sells her $500,000 permanent life policy to an institutional buyer for $140,000, well above its $65,000 cash surrender value. This transaction is best described as:

1. A.A life settlement, in which a third-party buyer becomes owner and beneficiary and pays the remaining premiumsCorrect. A healthy older insured selling to a third party above cash surrender value is a life settlement.
2. B.A viatical settlement, because the policy was sold rather than surrenderedViatical settlements involve a terminally or chronically ill insured, which is not the case here.
3. C.A surrender of the policy to the insurer for its cash valueA surrender would have paid only the $65,000 cash value, and the insurer, not a third party, would be the counterparty.
4. D.A Section 1035 exchange into a new contractA 1035 exchange swaps one contract for another; here the policy is sold for cash to an investor.

Why: A life settlement is the sale of an existing life insurance policy to a third party for more than its cash surrender value but less than its face amount. The buyer becomes the owner and beneficiary and takes on the obligation to pay the remaining premiums. A viatical settlement is the same structure where the insured is terminally or chronically ill, and it carries more favorable tax treatment for the seller; a settlement by a healthy older insured is a life settlement.

Proceeds a terminally ill insured receives from a qualifying viatical settlement are generally:

1. A.Always fully taxableWhen the insured meets the terminal-illness definition, the settlement is treated much like a death benefit received early and is generally excluded from income. Always overstates the rule in the wrong direction.
2. B.Subject to a 10% penaltyEarly-distribution penalties belong to retirement accounts, annuities, and MECs. Selling a policy under a qualifying viatical arrangement carries no such charge.
3. C.Income-tax-free to the insuredCorrect - a living benefit for terminal illness.
4. D.Taxed as a capital gain alwaysA sale did occur, so gain treatment is a reasonable instinct, but the rules carve out an exception for a qualifying terminally ill insured and exclude the proceeds from income entirely. Gain analysis matters for an investor who later buys the policy, not for this seller.

Why: Amounts received under a qualifying viatical settlement by a terminally ill insured are generally excluded from income.

When a viatical/life-settlement investor collects the death benefit after the insured dies, the investor:

1. A.Generally owes tax on the gainCorrect - investor gain is taxable.
2. B.Receives everything tax-free like the insuredRightly recalls that death proceeds are ordinarily tax-free, and that a terminally ill viator's sale can be excluded. That relief attaches to the insured, though, not to a purchaser holding the contract as an investment.
3. C.Forfeits the benefitAssumes the investor fails the insurable interest requirement at the moment of death. Insurable interest must exist when the policy is issued, so a legitimate purchaser still collects the benefit.
4. D.Owes no tax everThe word ever overstates it. The investor's gain, meaning the benefit less the purchase price and premiums paid since, is generally taxable when the claim settles.

Why: An investor who buys a policy generally owes tax on gain when the benefit is paid, unlike the terminally ill insured.