Are insurance settlements taxable?
Life insurance benefits and settlements for home and car insurance claims are generally not considered to be taxable income. As you file your taxes this year, you probably won’t have to dig out insurance-claims documents.
But as you might expect, there are certain cases where your state or the federal government may claim a share of the insurance money, explains Conrad Davis, a certified public accountant and partner with Ueltzen & Co. in Sacramento, Calif.
Home and car insurance settlements
When it comes to homeowners and car insurance policies, the general rule is that settlements are not taxable as long as they do no more than make you financially “whole” after a mishap, such as a car accident or damage to your home. If the insurance money paid to you replaces lost property or serves as compensation for injuries or lost wages, you will likely not face a tax bill.
"If you really think about what insurance is, it is money replacing some asset," says Davis.
When automobiles are damaged, car insurance compensation rarely exceeds the purchase price, since cars depreciate over time. That means there is no taxable gain.
"If you bought a car for $20,000 and it is smashed up and the insurance company gives you $15,000, there should be no tax in that situation," Davis explains. Whether or not choose you restore the damaged car does not affect a taxable gain.
But if a car insurance or home insurance settlement exceeds the original cost of your property, the money could be considered income. In addition, any sum you may have deducted for medical expenses that are later covered through an insurance settlement can be considered income and subject to taxation.
Life insurance proceeds
While life insurance benefits typically are not taxed, there are exceptions.
"Generally speaking, life insurance is tax-free because the premiums are not deductible," Davis says.
However, if you have group life insurance through work and your employer pays the premiums, your beneficiaries may have to pay tax on the death benefit, says Stephen Hamilton, a Philadelphia tax attorney who is a partner in Drinker Biddle & Reath LLP.
Usually, when you collect a death benefit under a life insurance policy, it will be exempt from federal or state income tax, adds Hamilton. However, if you were to sell your life insurance policy to an investor in order to collect money before your death, different rules could apply to the investor. This type of transaction is known as a “life settlement,” and investors could be subject to a tax if the death benefit exceeds what they paid for the policy.
Death and taxes
Life insurance benefits also may be subject to state and federal estate taxes, depending on the size of the estate and the state in which you live. If you own your own life insurance policy, it will be included when calculating the amount of your estate. Therefore, if your life insurance policy pushes your estate’s value over the threshold, then it becomes a taxable estate. In 2016, that threshold is $5.45 million.
The life insurance proceeds are taxable if your estate is subject to estate tax, however, this is only true if you own your own policy. If your spouse or beneficiaries own the policy, if won’t be counted with your estate. Also, if your spouse is the beneficiary of your estate, it won’t be taxed, as only estates passed on to children or others are subject to estate tax.
If you want to remove your life insurance from your estate, you can transfer ownership to another person or to a trust, then the other person or the trust will be responsible for paying the premiums.
"That will keep the insurance benefits out of your estate, but it is complicated," says Hamilton.
To prepare for this and other complex tax matters associated with life, home and car insurance benefits, he recommends seeking guidance from an expert for your specific circumstances.