Meet Samuel.

Samuel, 58, has played an integral role at an investment bank on the busy streets of Wall Street. As he nears retirement age, he wants to convert his key-man term policy from his company to permanent insurance, then sell it on the secondary market since he has no kids.

Even though Samuel can receive a large sum of money with his plan, there are still tax implications to Life Settlements. Normally with an insurance policy that pays a death benefit, the beneficiaries receive the monetary benefits tax-free. Life settlements, on the other hand, gives the owner of the policy benefits while still alive, therefore, the lump-sum payment is taxable. In addition, that big chunk of change can cut into some people's ability to participate in certain state or federal public assistance programs, most notably Medicaid.

The taxation of life settlements occurs when the life settlement value of the policy is greater than the premiums paid on the policy. When this occurs, the proceeds will be taxed in three levels. Please note that when the premiums paid into a policy exceed the life settlement, this is treated as a capital loss.

Tax Level 1

Cost Basis: the total premiums paid into the policy. This portion is tax-free. The Internal Revenue Code (IRC) regards this as a return of capital.

Tax Level 2

Ordinary Income: the portion exceeding total premiums paid into the policy (your the cost basis), but not exceeding the cash surrender value (the cash value the insurer of the policy will pay the insured when the policy is surrendered). The Internal Revenue Code (IRC) regards this as income, and as such is taxed as ordinary income.

Tax Level 3

Long-Term Capital Gains: the portion exceeding the cash surrender value. This portion is taxed as long-term capital gains. The Internal Revenue Code (IRC) regards this as the disposition of a capital asset.