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What Is Income Tax Planning For The Terminally Ill?

Terminal illness changes your financial outlook. It may be that you require more current income due to increased medical expenses or a change in lifestyle. Or perhaps transferring assets to your loved ones and engaging in estate planning is foremost on your mind. In either case, minimizing your payment of federal income taxes is likely to be one aspect of your general tax planning if you are terminally ill.

Unfortunately, terminal illness often prohibits continued employment. Consequently, depleting or liquidating investment funds, retirement plans, and insurance policies may become necessary to generate sufficient cash. It is important to understand the tax ramifications of your financial decisions. It is also important to understand the extent to which your medical expenses may be deducted on your federal income tax return. Income tax planning for the terminally ill involves four general areas: general income and deduction issues, insurance considerations, retirement planning, and the income tax consequences of estate planning.

What Are Some of The Income and Deduction Issues That May Be of Particular Concern to The Terminally Ill?

In general, terminal illness results in a drastic lifestyle change. An illness often limits your ability to earn money. Further, your medical expenses frequently increase. In each case, significant income tax implications are involved. Depending upon a number of factors, the manner in which you liquidate your assets may impact the amount of income tax you will pay. In addition, you should be aware that the medical expense deduction is broader than most people realize. This deduction can be used to reduce your tax liability.

Need for Increased Income

If you are terminally ill, you will probably need to increase your income in order to offset expenses associated with your illness. In addition, if you can no longer work, you will need additional funds to cover your living expenses. You may have to liquidate your investment, retirement, or insurance assets. Since you generally control when you recognize income or gain, you generally can control when you incur income tax liability. If you have a diversified and varied investment portfolio, you can liquidate loss and long-term capital gain assets first.

Unfortunately, some of your assets will create ordinary income, rather than generally more favorable capital gain income. Indeed, for many people, a retirement plan will hold the bulk of their investment assets. Be aware that withdrawals from a retirement plan will typically result in ordinary income.

Deduction of Medical Expenses

Medical expenses are deductible to the extent that they exceed 7.5 percent (10 percent in 2021) of your adjusted gross income (AGI). These deductions reduce your ordinary income. The medical expense deduction, however, is limited to unreimbursed medical expenses. It is important to keep detailed records of your medical expenses.

The need for extra income during a terminal illness is often associated with the need for medical care. Medical expenses include such disbursements as transportation to and from your physician for medical treatment, long-term home care, and insurance premiums. Improvements to your residence necessitated by your disability are also deductible to the extent they exceed any increase in value to your home. Medical expenses in the year of death may be used as either an income tax deduction or an estate tax deduction, but not as both.

Capital Losses

Generally, capital loss carryforwards are lost upon death. If sufficient loss carryforwards exist during your lifetime, an increased need for income might best be served by recognizing capital gain income, which can be sheltered by your loss carryforwards.

Tip: Depending on filing status, your surviving spouse may be able to use your loss carryforwards after your death.

Which Insurance Issues Are of Particular Interest to The Terminally Ill?

In some cases, insurance policies may provide a source of cash for the terminally ill. For instance, you may be able to access life insurance benefits by selling your life insurance policy to investors. (This transaction is commonly known as a viatical settlement.) In addition, you may have access to payments from disability, health, or accident insurance provided by your employer. Income tax planning for the terminally ill seeks the best after-tax return on these insurance vehicles. This approach is twofold. First, the taxation of insurance proceeds must be considered. Second, you need to compare the after-tax return available on all your investments.

Viatical Settlements And Accelerated Death Benefits

Viatical settlements involve the sale of your insurance policy benefits to investors. Amounts received from a life insurance contract on the life of a terminally ill or chronically ill person are excluded from gross income if certain requirements are satisfied. In addition, the sale or assignment of a life insurance contract to a viatical settlement provider is not taxed if certain requirements are satisfied. Accelerated death benefits and viatical settlements allow you to gain access to the death benefit while you are still alive.

The return to the viatical settlement provider is the difference between the discounted value paid for the policy and the full value of the policy upon your death. This return to the viatical settlement provider can also be viewed as your transaction cost, in a sense; it is the amount that would otherwise go to your beneficiaries. Viatical settlement companies buy almost any type of life insurance policy (including term, universal, whole, and group). The policy must be in good standing, it can contain no prohibition against assignment, and it generally must have been in force for at least two years. Typically, you must produce a medical certificate attesting to imminent death. Payment is usually made in the form of a lump sum. The primary risk to the company involves determining life expectancy. Note, however, that a viatical settlement might jeopardize your eligibility for Medicaid or other government benefits.

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Viatical Settlements Vs. Liquidation of Other Investments

Viatical settlements are not taxed if certain requirements are met; nevertheless, they might not necessarily represent the best approach for you. After considering your financial needs and specific goals, you should compare the consequences of a viatical settlement with the total cost associated with liquidating some or all of your other investment assets. Viatical settlements can provide access to cash that you might not otherwise have. However, if you have a variety of different investments, the tax and transaction costs of liquidating retirement accounts or other investment holdings may be lower then the total cost of a viatical settlement. Bear in mind that medical expense deductions may be wasted if you do not generate sufficient taxable income.

Example(s): Assume you are terminally ill and expect to live another 6-12 months. You need $50,000 to replace a lost income stream and $50,000 to pay additional expenses related to your illness. Half of your additional expenses will potentially qualify as deductible medical expenses. In addition, you would like to leave loved ones at least $100,000. At present, you have the following assets: (A) stocks worth $50,000 with a built-in gain of $25,000 (the gain is long-term capital gain); (B) a life insurance policy worth $120,000; and (C) a qualified retirement plan with a balance of $50,000. (Distributions would be taxed at ordinary income tax rates.)

Example(s): First, assume that you decide to liquidate the insurance to pay your various expenses. The market cost of your viatical settlement comes to $20,000. (Assume that the settlement meets the requirements for tax-free treatment.) Upon your death, the stock will receive a step-up in basis. Thus, this asset will not result in any tax to your beneficiaries. When you die, the retirement plan assets will be taxed at ordinary income tax rates. Thus, the beneficiaries will get less than $100,000. The total cost of this approach equals the cost of the viatical settlement of $20,000, plus taxation of the retirement benefits when distributed to the beneficiaries.

Example(s): Assume, instead, that you decided to liquidate your stock and retirement plan first. You would then sell only a portion of the insurance to make up any shortfall. The tax cost of the sale of stock is $3,750 (assuming a 15 percent maximum rate applies, 15 percent x $25,000=$3,750). Assume the tax cost of the retirement distribution is approximately $5,250 (after taking into account the medical expense deduction). You then liquidate the insurance policy to the extent necessary to make up the $10,000 shortfall. Assume a transaction cost of $2,500. In this case, you are able to leave over $100,000, tax free, to your loved ones. Your total cost amounts to approximately $12,500. Comparatively, liquidation of the insurance policy — while without tax cost — is less favorable. (Of course, liquidation of the insurance policy may very well prove more beneficial under a different set of facts. It is important, however, to assess the costs of each possible transaction.)

Disability Insurance

Disability insurance policies typically pay a percentage of your income if you become sick or disabled and unable to work at your occupation. If you pay the disability premiums, the benefits are not taxable. If disability insurance is provided through your employer, the benefits may be taxable if your employer paid the premiums and the premiums were not considered taxable income for you. However, the disability benefits will not be taxable if they represent merely a reimbursement of your medical expenses, permanent loss or loss of the use of part of the body, or disfigurement. In general, you cannot deduct the premiums.

What Should You Know About Retirement Plan Distributions?

Retirement plan distributions are often necessary to maintain the standard of living for the terminally ill. But this creates two problems: first, distributions from qualified retirement plans are taxed at ordinary income tax rates; and second, taking such distributions sacrifices tax-deferred growth.

Retirement Distributions And Tax Liability

The terminally ill are not subject to the 10 percent early distribution penalty, because they are treated as disabled. The bad news is that distributions from qualified retirement plans are taxed at ordinary income tax rates. Since our tax system is progressive, large annual distributions can increase your marginal tax rate for the year in which distributions are received. Thus, the tax cost of accessing these funds can be significantly higher. However, increased deductions from your medical expenses may offset part of an increase in your tax liability. A strategy that liquidates loss investments or long-term gain assets may actually be preferable.

Conversion of your tax-deferred retirement funds into a Roth IRA may provide a number of tax benefits. Qualifying distributions from a Roth IRA are tax free. Thus, Roth IRAs have the potential to help you increase your income stream without increasing your tax liability. Of course, converting funds to a Roth IRA is a taxable event. Given an abbreviated life span, this is probably not a beneficial strategy. However, taxpayers with significant deductions may want to consider a shift of retirement assets into the Roth IRA.

Taxation of Retirement Distributions After Your Death

Potential tax-deferred growth is one of the major benefits of a qualified retirement plan. With appropriate planning, this tax-deferred growth can be passed on to beneficiaries of your estate (of course, with the exception of qualifying Roth distributions, distributions after your death will generally be subject to federal income tax). But to the extent that you take distributions while you are alive, you sacrifice some of this tax benefit.

How Does Estate Planning Impact Your Income Taxes?

Retirement planning can certainly have an impact on your income tax position. In addition, your estate planning goals should be coordinated with your income tax planning.


Gifting can be used to eliminate or reduce assets that generate ordinary income. Why would you give away income producing assets when you need a greater income stream? Well, you might wish to spend down retirement assets and pass on investment securities to loved ones. Accomplishing this task prior to your death reduces your taxable income. Furthermore, you are not taxed on the built-in gain in an asset when you give it away. Unfortunately, this type of gift has income tax implications for the gift beneficiary, since he or she will have to pay tax on the built-in gain if and when the asset is sold.

Charitable Giving

Charitable giving may also offer you several tax saving opportunities. The charitable contribution is tax deductible (subject to certain limitations), so it can reduce your taxable income. Giving an unproductive asset away while increasing your income stream allows you to reduce your tax liability. Further, you can give away a partial interest in property. For instance, certain arrangements permit you to retain the use of property, such as your home, while currently making a gift of the value of the remainder interest.

This strategy ensures use of a residence until your death, yet it also provides a deduction against current income. Your beneficiaries will not get the property when you die, but your current use of the property is not diminished.



This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.


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Tags: Financial Planning, Lump Sum, Pension, Retirement Planning