Know Your Tax Responsibilities on Insurance

When purchasing life insurance, it is important to consider all of the circumstances that could affect the amount of money needed by beneficiaries. One issue everyone should consider is taxation. Many people wonder if they have to pay taxes on life insurance. Many people assume that all proceeds from life insurance are tax-exempt, but the truth is actually more complicated.
Death benefits of a life insurance policy, in general, are free from federal income tax when distributed by the insurance company to a named beneficiary or multiple beneficiaries. In other words, when a husband dies, his wife usually does not have to pay taxes on the money she receives from the insurance company as payment. If the husband has a $100,000 life insurance policy, the wife does not have to pay federal income taxes on that $100,000.

Things begin to get more complicated if the husband, before his death, instructs the insurance company to pay that $100,000 in installments of, say, $20,000. The insurance company will distribute the money as instructed. The money on deposit will earn interest, which is taxable. The principle is not taxed, no matter how it is distributed.

Another complication occurs when the owner of an insurance policy transfers ownership to another person or party before his death, for money or other consideration of value. The benefits paid to the beneficiary in this case could be considered taxable income. This should be discussed with a tax professional before completing such a transaction.

Anyone purchasing life insurance should know that life insurance policies may be subject to federal estate tax (not income tax) if the deceased has an ownership interest in the policy. If the insured person has any control over the policy, including the right to cancel it, borrow against it or change the beneficiary, that person is considered to own the policy. When the owner of the policy dies, the proceeds may be subject to federal estate tax. In most cases, if the beneficiary is the spouse, estate tax is not assessed on the insurance benefits. However, these taxes may be assessed when the spouse dies. This issue should be discussed with a professional during estate planning.

It may seem unreasonable that any insurance benefit should be taxed. As stated, life insurance proceeds paid to a beneficiary are usually not subject to federal income tax. Other tax situations may arise and should be discussed with a qualified professional.

But what about the question of insurance being taxed? With the value of employee health benefits appearing on the 2011 Form W-2, many people worry that their health insurance is being taxed. This is not the case. The health benefits information is printed on the W-2 for informational purposes only.

However, in 2018, insurers will pay a 40% tax on the portion of “Cadillac” health plans sponsored by employers that exceeds $10,200 for individuals or $27,500 for families. Insurers are likely to pass the higher costs along to employers. Employers will likely pass the costs to employees or reduce coverage to slip under the tax threshold. For now medical insurance benefits, like life insurance benefits, are not subject to federal income tax.


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