J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

17.16 Life Insurance Used by Chronically ill or Terminally ill Persons

A person who is terminally ill may be forced to cash in a life insurance policy to pay medical bills and other living expenses. Insurance companies have developed life insurance policies with accelerated death benefit clauses to help terminally ill patients meet the high cost of medical care. Where a policy lacks an accelerated payment clause, it is also possible to sell a life insurance policy to a viatical settlement company that specializes in buying policies from ill persons who require funds to pay expenses.

Accelerated death benefits and viatical settlement proceeds received by terminally ill individuals are not taxed.

Payment of long-term care costs.

A chronically ill (17.15) individual may sell a life insurance policy to a viatical settlement company to pay for long-term-care costs. However, tax-free treatment is determined under the tax rules applied to long-term-care policies (17.15). Thus, if the proceeds exceed the $310 per diem limit for 2012 and also exceed actual long-term care costs, the excess is taxable on Form 8853. Accelerated life insurance proceeds paid under a long-term-care rider are also subject to these rules (17.15).