Viatical Settlements for CFP® Professionals

00:00:08 

Hello everyone, and welcome back to another awesome episode of the BIF Bites Podcast. I’m your host, Jerry Mee, and this week we are going to be learning all about viatical settlements and what you need to know about them for the CFP exam. 

Before we dive into viatical settlements, we need a bit of foundation. We need some groundwork knowledge to set the stage in order to fully understand viatical settlements. That bit of foundational knowledge is what is known as the transfer for value rule. 

With life insurance, it’s typically tax-free. The big exception to that is the transfer for value rule, which says if you sell your life insurance policy to a third party for a gain, that gain is taxable. Basically, the IRS is saying, you are not really using this as life insurance anymore. You are using it as an investment vehicle with your life as the underlying asset. 

00:01:21 

Because you are not treating it as life insurance, it is no longer tax-free. The IRS will tax you on any gains, which means the difference between your premiums paid and what you receive for selling that policy to a third party. There are a few exceptions to this transfer for value rule, such as transferring the policy to a spouse, a close business partner, or to a business in which you are an owner or officer. But the big exception we are focusing on today is the viatical settlement. 

00:02:12 

A viatical settlement allows you to sell your life insurance policy to a completely unrelated third party and not have to pay any taxes. However, there is a catch, and it is a big one. You must be either terminally ill or chronically ill in order to qualify for a viatical settlement. It gives flexibility to individuals who are terminally ill by allowing them access to cash to take care of any final wishes. This is the main purpose of a viatical settlement. It lets people who have been medically diagnosed access cash that would otherwise be unavailable to them, and it is tax-free. 

00:03:24 

You must be diagnosed by a medical professional as terminally ill, specifically with a life expectancy of 24 months or less. Another way to qualify is to be diagnosed as chronically ill. That means being unable to perform two of the six Activities of Daily Living, or ADLs. The acronym to remember is BEDCOT: bathing, eating, dressing, continence, toileting, and transferring on and off the toilet. If you cannot perform two of those six, you qualify as chronically ill and can also take a viatical settlement. 

00:04:25 

There is an additional restriction for chronically ill individuals. The settlement money can only be used to pay for qualified long-term care costs. Terminally ill individuals, however, can use the money however they wish. They can travel, fund grandkids’ college accounts, or spend it freely. 

00:05:03 

We have established who qualifies for viatical settlements and who can receive them tax-free. But that does not mean there are no taxes involved at all. Viatical settlements are tax-free for the terminally or chronically ill individuals, but the viatical company still owes taxes on its gains because it is operating as a for-profit business. 

The company will not give the full face value of the policy to the individual. It keeps a portion as profit. Any gains it makes are taxable, and those calculations must include ongoing premium costs. 

00:06:09 

Let’s look at an example. Suppose a terminally ill individual has a life insurance policy with a $500,000 death benefit. They decide to access that value while still alive and contact a viatical company. The company will not offer the full $500,000 because it needs to make a profit. It might offer $300,000 for the policy. 

00:07:05 

The terminally ill individual receives $300,000 tax-free and can spend it however they like. When they eventually pass away, the viatical company receives the $500,000 payout from the insurance company, making a $200,000 profit—if the insured person passes away quickly. 

In reality, the person may live longer. If they live several more years, the viatical company must continue paying premiums to keep the policy active. Suppose over two years they pay $50,000 in premiums. Their total cost basis becomes $350,000, which reduces their taxable gain. 

00:09:32 

When the insurance company pays $500,000 to the viatical company, the gain is $150,000, which is taxable. This is the type of question you may see on the CFP exam. They may ask for the taxable amount for the terminally ill individual, which is zero, and for the viatical company, which includes premium payments in its cost basis. Always account for those additional premium payments in your calculation. They reduce the taxable gain. 

00:11:07 

One last related topic is the Accelerated Death Benefit, or ADB. These are similar to viatical settlements but cut out the middleman. The ADB is a rider added to the life insurance policy itself, allowing the terminally ill policyholder to access the cash value directly from the insurer. 

It functions much like a viatical settlement, allowing a terminally ill individual to access cash tax-free, but without involving a third-party company. The rider may slightly increase premiums, but it gives flexibility to withdraw part of the death benefit while still alive. 

00:12:08 

That wraps up our lesson on viatical settlements. It was a shorter episode, but we covered several key CFP exam concepts: the transfer for value rule, BEDCOT and the ADLs, accelerated death benefits, and how viatical settlements work in real life. 

If you enjoyed this lesson and want more CFP prep material, join us in the BIF Review. We’ll help you earn those CFP marks and feel confident on exam day. Until next time, I’m Jerry Mee, and we’ll see you in two weeks for our Questionpalooza episode. 

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That episode will be our final one before the November exam. Adam, Kaylee, and I will walk through a series of mock questions styled like the CFP exam to help you get ready. I’m really excited for that one. See you all in two weeks.