In general, the proceeds from a life insurance policy that you receive as beneficiary upon the death of the insured are not subject to U.S. federal income tax, unless the policy has been turned over to you in return for a price. In order to determine whether any part of the benefits is taxable, a distinction must be made between benefits that are paid as a lump sum and those that are paid in installments.
When you receive proceeds from a life insurance policy in a lump sum, you include in your taxable income only the portion of the payment that is in excess of the amount that should have been paid to you at the time of the death of the insured. When this amount is not defined, the taxable portion of the benefits would be the excess of the payments you receive over the present value of the payments on the date of death.
When you receive the benefits from a life insurance policy in installments, you can exclude part of each payment from your taxable income. The part of each installment that you can exclude is generally calculated as the lump sum the insurance company had to pay at the time of the insured person’s death divided by the number of installments you are going to receive. The portion of each installment that exceeds this excludible amount would be declared as interest income. Interest income is reported on line 8a of Form 1040, or on line 8a of Form 1040A. If the total of all interest you receive, including interest from other sources, is over $1,500, you must file Schedule B if you file your return on Form 1040, or on Schedule 1 if you file using Form 1040A.
When you are the beneficiary of a life insurance policy as the surviving spouse and your spouse died before October 23, 1986, you can exclude up to $1,000 per year of interest included in the installment payments. You can continue claiming the exemption even if you remarry.
Surrender of Policy for Cash
When you surrender a life insurance policy for cash, the part of the proceeds you receive that is subject to tax is the amount by which the benefits you receive exceed your cost in the policy. Your cost generally consists of the premiums you have paid for the policy, less any refunded premiums, rebates, dividends, or any loan you have taken based on your investment in the policy and that you have not repaid.
The insurance company should send you a Form 1099-R, indicating the amounts paid to you and the part of those payments that is taxable. You report the total amount on line 16a, for pensions and annuities, of Form 1040, and the taxable part n line 16b. If you file your return using Form 1040A, these amounts are reported on lines 12a and 12b. If you have taxable amounts to report from a life insurance policy, you cannot use Form 1040EZ.
In an endowment contract, you receive a specified amount of money on a certain date, unless you die before that date, in which case the money is paid to your designated beneficiary. When you receive a lump sum on the date defined for the payment of the benefits, you are subject to tax on the portion of the payment that exceeds your cost in the policy. Your cost is calculated as the total of all premiums paid for the insurance policy less any amount previously received from the policy that you excluded from your taxable income.
Exclusions for Chronic or Terminal Illness
When the insured person has a chronic or terminal illness, certain amounts of accelerated death benefits received before the insured’s death can be excluded from taxable income.
For tax purposes, a person is considered to have a terminal illness when a physician has certified that the person has a chronic illness or condition that can reasonably be expected to result in the person’s death within a period of 24 months from the date of certification. In this case, the accelerated death benefits received from the life insurance policy are fully excludible from taxable income.
A person is considered to have a chronic illness when within the previous 12 months a licensed health care practitioner has certified that for at least 90 days the individual is unable to perform at least two activities of daily living, such as eating, toileting, transferring, bathing, dressing, and continence, without substantial assistance due to loss of functional capacity; or the person requires substantial supervision to be protected from threats to health and safety due to severe cognitive impairment.
When the insured person has a chronic illness, installment payments to cover the costs incurred for long-term care services are fully excludible from taxable income. Accelerated death benefits paid on a per diem or other periodic basis are excludible up to a limit. En general, this limit is $260 per day for 2007. This limit applies to the total accelerated death benefits and any periodic payments received from long-term health care insurance contacts.
Long-Term Health Care Insurance Contracts
In order to qualify as a long-term health care contract, the contact must be guaranteed renewable; it must not provide for a cash surrender value; it must provide that reimbursements, other than those paid on the death of the insured, or due to complete surrender or cancellation of the policy, can only be used to reduce future premiums or to increase future benefits; and it must not pay or reimburse expenses that would be covered by Medicare, except when Medicare is the second payer, or when the contract provides for payments on a daily or other periodic basis, without taking into account the expenses.
Qualified long-term health care services include necessary diagnostic, preventive, therapeutic, curing, treating, mitigating, and rehabilitating services, and maintenance and personal care services. The services must be required by a person who has a chronic illness and must be provided in accordance with a health care plan prescribed by a licensed health care practitioner.
Form 8853 to Claim the Exclusion
In order to claim the exclusion of accelerated death benefits paid on a daily or other periodic basis, you need to file Form 8853, “Archer MSAs and Long-Term Care Insurance Contracts”, with your annual federal income tax return. You do not have to file this form in the case of benefits paid based on actual expenses incurred for long-term health care services.
Interest on a Loan to Purchase or Maintain a Life Insurance Policy
Generally, you cannot take a tax deduction for interest on a loan to purchase or maintain a life insurance policy, endowment contract, or annuity contract if you intend to systematically borrow the increase in the cash surrender value of the policy or contract. This rule applies to the total amount borrowed, and not just the amounts borrowed that correspond to the increases in the cash surrender value.