Like most responsible adults, you have bought a life insurance policy to protect your loved ones in case of catastrophe. You purchased it to provide a means of support to your family in case you lose the means to produce income. Let us look at some of the aspects of insurance, and the effects they have on your taxes.
Let’s say you had a rich aunt who names you as the beneficiary in her life insurance policy. She then dies in a freak stand up paddle board accident. You receive $1,000,000 from the insurance company. Is this taxable?
It depends. If you receive the money in a lump sum, it is not taxable. However, if the settlement option is selected, part of the amount is taxable. As payments are made over time, payments will include principal and interest. You would pay taxes on the interest, but the amount paid out as principal would be tax-free. If you receive $60,000 a year over twenty years, then $50,000 would be tax-free, while $10,000 would be taxable.
Maybe you got a call or letter from your insurance company saying they are going to send you a dividend check. Before you get too excited keep in mind that dividends from an insurance company are just an amount you over paid on your premiums. Since these are returns of unused premiums, they are not taxable.
However, if you tell the insurance company to hold on to the money so that it can earn interest, the amount you receive in interest is taxable to you.
Your insurance policy may have a cash value, which will grow over time. The taxes on the cash value of your policy will be deferred until the policy is surrendered. Once the policy is deferred, the amount of cash value greater than the premiums that you have paid in will be taxable to you.
If you become terminally or chronically ill, your insurance company may extend accelerated benefits to you. If you are terminally ill, the amounts you receive are considered tax-free. However, if you chronically ill, only part of the payments are tax-free. At a certain limit, the amount you receive greater than this limit are taxable.
Do you have an insurance policy, or are set to receive money from an insurance policy you or someone else has? Drop me a line at email@example.com, and I would be happy to answer any questions about how your taxes will be affected by any payouts. If you need help with other tax questions, or with preparing a return, drop me a line, and we can discuss your situation.
In accordance with Circular 230 Treasury Department Regulations, I am required to advise you that any tax advice contained in this article may not be relied upon to avoid penalties under the Internal Revenue Code. If you are interested in a written opinion that can be relied upon to prevent the imposition of tax-related penalties, please contact the author.