Life Insurance Proceeds Tax-Free, but Interest Income Not - By: StrataTax

Life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. This is true even if the proceeds were paid under an accident or health insurance policy or an endowment contract. However, the interest income received as a result of life insurance proceeds may be taxable.

Proceeds Not Received in Installments. If you receive death benefits in a lump sum or other than at regular intervals, include in your income only the benefits that are more than the amount payable to you at the time of the insured person’s death. If the benefit payable at death is not specified, you include in your income the benefit payments that are more than the present value of the payments at the time of death.

Proceeds Received in Installments. If life insurance proceeds are paid to you in installments, part of each installment can be excluded from your income. To determine the excluded part, divide the amount held by the insurance company (generally the total lump sum payable at the death of the insured person) by the number of installments to be paid. Anything over this excluded part is to be included in your income as interest.
Example: The face amount of the policy is $90,000 and, as beneficiary, you choose to receive 120 monthly installments of $1,000 each. The excluded part of each installment is $750 ($90,000 ÷ 120), or $9,000 for an entire year. The rest of each payment, $250 a month (or $3,000 for an entire year), is interest income to you.

Installments for Life. If, as the beneficiary under an insurance contract, you are entitled to receive the proceeds in installments for the rest of your life without a refund or period-certain guarantee, you figure the excluded part of each installment by dividing the amount held by the insurance company by your life expectancy. If there is a refund or period-certain guarantee, the amount held by the insurance company for this purpose is reduced by the actuarial value of the guarantee.

Surviving Spouse. If your spouse died before October 23, 1986, and insurance proceeds paid to you because of the death of your spouse are received in installments, you can exclude up to $1,000 a year of the interest included in the installments. If you remarry, you can continue to take the exclusion.

Surrender of Policy for Cash. If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. In general, your cost (or investment in the contract) is the total of premiums that you paid for the life insurance policy, less any refunded premiums, rebates, dividends, or unrepaid loans that were not included in your income.

You should receive a Form 1099-R showing the total proceeds and the taxable part. Report these amounts on lines 16a and 16b of Form 1040 or lines 12a and 12b of Form 1040A.

Your tax preparer can provide you with more information regarding the treatment of life insurance proceeds on your income tax return. StrataTax, a San Diego consulting and tax services firm, is available year-round to assist you with income tax preparation and tax planning. Call us at (858) 225-7720 to setup your free initial consultation or visit us at http://www.StrataTax.com for more information.

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