Insurance Payments: Income Or Not?

Whether or not insurance payments are considered income depends on the type of insurance and the nature of the claim. For example, money received as part of a property insurance claim, medical claim, or compensation for repairs or replacement of damaged property is generally not taxed. On the other hand, life and disability insurance claims may be taxed as income. Interest accrued on a life insurance payout or cash withdrawals from a life insurance policy while the insured person is still alive is also considered income and taxed accordingly. Additionally, if you receive insurance benefits through an employer-sponsored plan, such as accident or health insurance, and your employer has paid the premiums, you must report this as income.

Life insurance payouts are generally not taxable, but there are exceptions

Exceptions to the Rule

The tax status of a life insurance payout depends on the type of policy, the size of the estate, and how the benefit is paid out.

Payout Structure

If the payout is set up to be paid in multiple instalments, these payments can be taxable. For example, an annuity is paid regularly over the life of the beneficiary and includes proceeds and interest.

Interest Accrued

If the policy has accrued interest, taxes are usually due. The amount that earned interest will be taxed, rather than the entire death benefit.

Surrendering Your Policy

If you surrender your policy, any funds over your policy's cash basis will be taxed as regular income.

Employer-Paid Group Life Plan

In some cases, an employer-paid plan that pays out more than $50,000 may be taxable according to the Internal Revenue Service (IRS).

Death Benefit and Estate Value Exceed Limits

If life insurance proceeds are included as part of the deceased's estate and together exceed the federal estate tax threshold (which was $13.61 million as of 2024), estate taxes must be paid on the proceeds over the allowed limit.

Policyholder Names the Estate as a Beneficiary

If the policyholder chose their estate as a life insurance beneficiary, taxes might apply depending on the estate's value.

The Insured and the Policy Owner are Different Individuals

If a different person holds each role, there may be taxes involved.

Withdrawing or Taking Out a Loan Against Your Whole Life Policy's Cash Value

If you withdraw more than your cumulative premium payments, you may have to pay income taxes on the excess.

Selling Your Whole Life Policy

If you sell your policy and the sales proceeds exceed your cumulative premiums, minus the portion of your premiums attributed to the cost of insurance, the excess may be subject to income taxes.

Dividends

Some life insurance companies offer dividends to whole life insurance policyholders. You generally don't pay taxes on life insurance dividends. However, if you let the insurer keep your dividends in exchange for interest, then you may pay income tax on the interest.

Interest accrued on life insurance payouts is taxable

Life insurance payouts are generally not considered taxable income. However, there are certain situations where the interest accrued on the payout may be taxable.

If the beneficiary of a life insurance policy chooses to delay the benefit payout and the money is held by the life insurance company for a given period, they may have to pay taxes on the interest generated during that time. This is because income earned in the form of interest is almost always taxable, and life insurance is no exception.

For example, if a beneficiary opts for periodic payments over a number of years instead of a lump-sum payment, the insurance company typically pays interest on the remaining balance. The tax code treats these installment payments similarly to annuities because the payout and tax-exempt amounts are known upfront. In this case, the beneficiary must pay taxes on the interest earned, not on the entire benefit.

If the beneficiary receives the payout as an annuity, any interest accrued by the annuity account may also be subject to taxes. This is because the interest accrued in the annuity account is considered taxable income.

Furthermore, if the life insurance policy is transferred to the beneficiary for cash or other valuable consideration, the exclusion for the proceeds may be limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. In this case, the beneficiary would generally report the taxable amount based on the type of income document received, such as a Form 1099-INT or Form 1099-R.

While life insurance payouts are typically tax-free, it is important to consider the specific circumstances surrounding the payout to determine if any taxes may apply.

Disability insurance payouts are taxable if you pay premiums with pre-tax income

Whether or not disability insurance benefits are taxable depends on who pays the premiums and whether they are paid with pre-tax or post-tax dollars.

If you pay the premiums for your disability insurance policy yourself, using post-tax dollars, then your benefits are typically tax-free. This is because you have already paid tax on this income, so you won't be taxed twice.

However, if you pay your premiums with pre-tax dollars, then your benefits are usually considered taxable income. This is because pre-tax dollars are income that has not yet been taxed. Therefore, when you receive your benefits, this income will be taxed.

If your employer pays for your disability insurance policy, or if you share the cost of the policy with your employer, then the benefits you receive are generally considered taxable income. This is because your employer has likely paid for the policy using pre-tax dollars. However, if you pay the entire cost of the policy yourself, with post-tax dollars, then your benefits are not taxable.

It is important to note that there may be exceptions to these rules, and the taxation of disability insurance benefits can be complex. It is always recommended to consult with a tax professional or financial advisor to understand your specific situation.

Long-term care insurance benefits are usually tax-free but may be taxed if they exceed medical expenses

Long-term care insurance benefits are typically tax-free. The IRS treats these payouts as reimbursements for medical expenses, which they don't consider taxable income. This applies whether the insurance company pays your long-term care bills directly or sends you cash as a per diem to cover your bills.

However, there are some circumstances in which your long-term care insurance benefits may be taxed. Firstly, if you receive cash on a per diem basis, there is a limit to how much of it can be tax-free. As of 2021, the maximum tax-free per diem is $400 per day. If your policy pays more than this, or if your expenses are lower than what you receive, the excess counts as taxable income. For example, if you receive $450 a day and your expenses are only $400 a day, the extra $50 is taxable.

Secondly, if you deducted a portion of your long-term care insurance premiums from your taxes, you may have to pay taxes on some of your benefits. This is because the benefits are reimbursements for expenses that you have already claimed a deduction for.

Thirdly, if your benefits are paid regardless of expenses incurred, there is a limit to how much can be excluded from your taxable income. For the 2020 tax year, the limit was $380 for each day. If you receive more than this for each day of long-term care, you may be able to deduct the excess as a medical expense.

Finally, the tax treatment of your benefits depends on whether you have a tax-qualified or non-tax-qualified policy. A policy is tax-qualified if it meets certain rules determined by the IRS, such as only paying out if you have a condition predicted to last longer than 90 days. A stay in a short-term care facility wouldn't qualify. Most policies are tax-qualified, but if yours is not, the IRS hasn't declared whether benefits from a nonqualified policy will count as taxable income in the future, so this regulation could change.

Homeowners insurance benefits are generally not taxable

However, there may be an exception in the case of an insurance claim on an investment property. If you don't reinvest the money fast enough to repair or replace the property, the insurance proceeds could be considered a taxable gain.

It's worth noting that while homeowners insurance benefits are generally not taxable, homeowners insurance premiums are also generally not tax-deductible. The Internal Revenue Service (IRS) considers homeowners insurance premiums nondeductible payments, much like the cost of utilities.

Frequently asked questions