Are Insurance Proceeds Subject to Federal Income Tax?

Whether insurance proceeds are subject to federal income tax depends on the type of insurance. Even though some types of insurance proceeds are not subject to tax, they may have other tax effects. The insurance proceeds you receive may reduce your deductible expenses or could affect the basis of your property for tax purposes.

Life insurance

Proceeds you receive from a life insurance policy that are payable upon the death of the person insured are generally not subject to federal income tax. Accelerated death payments received from a life insurance contract when the person insured is terminally ill are exempt from tax. If the person insured is chronically but not terminally ill, the portion of the accelerated death payments to cover long-term health care is excluded from taxable income. The portion that is paid on a per diem or other periodic basis is excludible up to a certain limit.

If you receive life insurance proceeds in installments, part of each installment may be subject to tax as interest. The amount of each installment that you can exclude from income is the total lump sum payable at death divided by the number of installments. The excess over that amount would be taxable interest.

If you have an endowment life insurance contract in which you receive a specified amount on a certain date, if the amount is payable in a lump sum, the excess over the amount of premiums you paid would be taxable income. If you receive the endowment proceeds in installments, they would be taxable as an annuity.

If you surrender a life insurance policy for cash, the amount of the proceeds in excess of the premiums you paid would be taxable. You should receive a Form 1099-R showing the taxable amount.

If you are covered by group life insurance at work, the cost your employer pays for coverage in excess of $50,000 is taxable income for you. This amount will be included in your wages and is reported separately in box 12 of your W-2 with code C. But you would not be subject to tax if you are permanently and totally disabled and ended your employment. If your group term insurance provides a permanent benefit such as a cash surrender value, the cost of the permanent benefits that your employer paid would be taxable income for you, minus any amount you may have paid.

Health insurance

The amounts you receive as personal injury or sickness benefits from a health insurance plan paid for by your employer would be taxable income to you. But any amounts paid to reimburse you for medical expenses are not taxable. The health insurance reimbursements would reduce the medical expenses you could claim as an itemized deduction. When you pay for the health insurance yourself, none of the benefits would be taxable. But insurance reimbursements for medical expenses would reduce your itemized deduction.

If you receive disability benefits from an accident or health insurance plan paid for by your employer, the benefits are taxable to you. If you paid part of the cost of the plan, only the portion of the benefits attributable to your employer's contributions is taxable.

Payments you receive from a long-term health care insurance policy are generally considered reimbursements of medical expenses and are not taxable. These benefits would reduce the itemized deduction you can claim for medical expenses. If you receive payments on a per diem or other periodic basis, you need to file Form 8853, Archer MSAs and Long-Term Care Insurance Contracts, with your tax return in order to exclude those payments from your income.

Workers' compensation insurance

Benefits you receive for a work-related injury or illness under workers' compensation insurance are exempt from tax. This includes payments to survivors. But it does not apply to retirement plan benefits, even if you retired due to an occupational injury or illness. The portion of your disability pension that applies to workers' compensation is exempt. The part that is based on your years of service would be taxable as pension or annuity income.

Auto and home insurance

Insurance proceeds you receive as a result of a theft, an accident or damage to your home are generally not taxable income. The insurance proceeds are taken into account in determining the amount of a deduction you may be able to claim for casualties, disasters, and thefts. And the insurance proceeds may affect your basis in the property for purposes of calculating depreciation if it is a business asset, and for determining your gain or loss if you eventually sell the asset. For more information, you can refer to IRS Publication 547, Casualties, Disasters, and Thefts, and Publication 551, Basis of Assets.

Sources:
Form 8853, Archer MSAs and Long-Term Care Insurance Contracts, IRS
Life Insurance & Disability Insurance Proceeds, IRS
Publication 525, Taxable and Nontaxable Income, IRS
Publication 547, Casualties, Disasters, and Thefts, IRS
Publication 551, Basis of Assets, IRS
Roy Lewis, How Does Insurance Affect Your Taxes, The Motley Fool