Whether you’ve received a payment to fix your roof or to replace your income while you recover from an accident, you’re likely to feel relieved that you had insurance and that it worked the way it’s supposed to. Before you spend that benefit, though, you might wonder if you ought to set aside some of the proceeds to pay income taxes on the money.
“Generally, if you’re paying premiums yourself, such as for homeowners insurance and auto insurance, then your insurance benefits are not a taxable event,” says Adam Sherman, CEO of Firstrust Financial Resources in Philadelphia. “Your benefits are reimbursement for expenses, rather than income.”
Still, there are times when an insurance payout or policy will attract the attention of the Internal Revenue Service or state tax authorities. Here’s a look at the various types of insurance, answering the question: Taxable or tax-free?
Benefits: Generally not taxable. When you are reimbursed for a claim to repair your home or even replace it if it’s destroyed, such as in a fire, no tax is owed.
“If you’re repairing damage to your personal residence, then your benefits are not taxable,” says Gregory Burke, a certified public accountant with John Waddell & Co. in Sacramento, Calif.
But he adds: “There may be an exception in the case of an insurance claim on an investment property, because the insurance proceeds could be considered a taxable gain if you don’t reinvest the money fast enough to repair or replace the property.”
Benefits: Generally not taxable. Insurance money you receive after a car accident or when your car has been stolen is not reported as income, says Burke.
“If you are repairing or replacing your personal vehicle, then you don’t have to pay taxes on the insurance benefit,” he notes. “However, if you deduct part of the cost of your car as a business expense, the insurance benefit might be considered a gain. You are only taxed on the benefit if the insurance reimbursement is above the amount of your tax deduction for the use of your car.”
Death benefits: Sometimes taxable. “Death benefits on an individual’s life insurance policy are not considered taxable income,” says Drew Tignanelli, president of the Financial Consulate, a financial planning firm in Hunt Valley, Md. “However, depending on the amount of the life insurance policy, how it is owned and the state where the deceased person lived, you (the beneficiary) could have to pay estate taxes on a life insurance policy.”
Federal estate taxes must be paid on life insurance benefits above $5.25 million in 2013, but only if the policy was owned by the deceased individual, says Tignanelli.
“If a life insurance policy is owned by the beneficiaries, they won’t have to pay an estate tax,” he says.
The minimum benefit subject to state estate taxes varies. For example, in Maryland, life insurance benefits of more than $1 million are subject to the state’s estate tax.
Dividends and interest:
Sometimes taxable. Unlike term life insurance policies, many permanent life insurance products earn dividends or interest.
“Dividends are typically considered a return of the premiums you have paid and are not taxable unless you previously deducted the premiums from your taxes,” says Burke.
But interest that accrues on a cash value life insurance policy will be considered taxable income, and you should receive a Form 1099 showing the total interest earned each year, he says.
Many insurance companies offer policyholders the option of using their interest to buy additional insurance. In that case, the interest is not taxed, Tignanelli says.
Benefits: Sometimes taxable. Whether disability insurance benefits are taxable depends on how you paid your premiums, says Sherman.
“If you pay your premiums with pretax income, then the benefits are considered taxable income,” he says. “If you pay the premiums with after-tax dollars, then the benefits are tax-free.”
Tignanelli says most disability insurance policies cover only 60 percent to 70 percent of your income if you become disabled, so he recommends purchasing your policy with after-tax income so you won’t have to worry about taxes if you have to receive benefits.
“It’s a lot easier to handle that drop in income if it’s tax-free,” he says.
Long-term care insurance
Benefits: Sometimes taxable. Sherman says long-term care insurance benefits are typically tax-free.
“However, some people can deduct a portion of their long-term care insurance premiums from their taxes,” says Sherman. “If you deducted some of your premiums, you may have to pay taxes on some of your benefits.”
Your benefits also could be taxed if they exceed your medical expenses.
“As long as you have a doctor attest to your need for care, some insurance policies will pay your benefits even if you are being cared for at home by a family member rather than incurring expenses in a nursing home,” says Tignanelli. “In that case, since you wouldn’t actually have reimbursable medical expenses, your benefits would be considered taxable income.”
Employee benefits: Sometimes taxable. Currently, health insurance is not taxed in most circumstances. But one exception is employer-sponsored health insurance for workers’ domestic partners, which is considered taxable income under federal law.
An employee must pay tax on what his or her partner’s coverage costs the company; some employers “gross up” an employee’s salary to cover that tax.
If a domestic partner qualifies as a dependent of the employee, then the health insurance coverage is tax-free, says Burke.
“In order for a domestic partner to be a dependent, the partners must reside in the same household and the other partner must provide over one-half of his or her support,” he says.