Posted on May 26, 2017
Taxation of Insurance Payouts by Product: A Quick Reference
Insurance products are incredibly complex. The policies can have documentation longer than most novels, filled with legal jargon, caveats, restrictions, riders, hidden fees, and a host of other variables that can at times make your mind spin. And those are the straight-forward policies. In addition, each type of insurance, from life to health to property and casualty, has a distinct tax profile for the money that owners/beneficiaries receive. Many people struggle to understand the tax implications of these payouts.
Here we try to alleviate some of the mystery, with a quick reference to the general tax payout profile of the most common insurance products. Of course, each insurance policy is unique and can be structured according to the provider’s desire to create a new product or differentiate from competitors, so make sure to read each policy in detail and consult a tax professional to fully understand its tax implications.
ANNUITY – Generally taxed as ordinary income, unless premiums were paid with after-tax money, in which case the amount of payments received, up to the value of the after-tax premiums, is not taxed. For immediate annuities and deferred annuities that are ultimately annuitized, the proportion of taxable payment is uniform across periods and is set based on the IRS’ estimate of one’s life expectancy (with adjustments for joint & survivor policies). For deferred annuity withdrawals, the value of the withdrawal is considered from interest and earnings (and taxed as ordinary income) until those amounts are exhausted. Income tax is owed on deferred annuity lump-sum payments and annuity death benefits, e.g., period certain and deferred annuities, above the after-tax premiums paid. There are some scenarios where an appreciated annuity can be exchanged, via a 1035 exchange, to a long-term care or long-term care/annuity hybrid policy and avoid taxation if that new policy triggers a pay-out.
A special kind of annuity, one created through a structured settlement for personal injury, harassment, discrimination, etc., and paid by the defendant through a 3rd party insurance company, avoids payment taxation (Periodic Payment Settlement Act of 1983).
TERM LIFE – Free from income tax, but subject to estate tax above the federal threshold ($5.45 MM in 2016) and state-level estate tax in some states, if policy was owned by the deceased. If policy was owned by the beneficiary or someone other than the deceased, there are no estate tax implications.
PERMANENT LIFE – Death benefits follow same rules as Term Life, but dividends earned on the cash value of these policies are taxed, depending on whether one previously claimed the insurance premiums as deductions (if after-tax, the dividends are return of premium and not taxed up to the total value of premiums paid). Interest earned on the cash value is taxed as income unless reinvested in additional insurance premiums.
PROPERTY (Home, Auto) – Generally not taxable if receiving payments for damage or loss. Common exceptions: 1) Real-estate investment property, where the payout is treated as capital gain if not reinvested in the property in a timely manner; 2) Car claimed as a deduction for business purposes, which triggers a capital gain if the payout is greater than the claimed deduction.
HEALTH – Generally not taxable, except in the case of domestic partners, where an employer-sponsored health plan pays the premiums for the employee’s domestic partner. In these cases, that premium is considered taxable income, unless the domestic partner qualifies as a dependent of the employee. If the domestic partners get married, the tax consequence of the premiums goes away.
DISABILITY – Benefits are taxable depending on whether one previously claimed the insurance premiums as deductions (if after-tax, the benefits are not taxed). Given that benefits are usually less than one’s salary and one is generally dependent on the benefits when payable, take caution when paying for these policies with pre-tax funds. Taxes will further reduce the funds that are paid out and available to cover the costs of living.
LONG-TERM CARE – Benefits generally not taxable, unless one claimed the premiums as deductions or the benefits exceed the cost of care, e.g., pro-bono home care by a family member, which can make that portion of the benefit taxable.
When reviewing your insurance options, keep these general tax attributes in mind. Insurance is often touted as having tax advantages, but, as outlined above, it really depends on the type of product (and potentially unique riders within the individual policy), its owner, and how the money was contributed at origination, among other variables.