In general, the IRS makes concessions for individuals who receive life insurance proceeds due to the death of an insured person by allowing them to omit such payments from taxable income. Under certain circumstances, however, amounts associated with life insurance proceeds must be reported as gross income on your personal tax return.
Lump Sum
If you opt to receive a life insurance proceed all at once, in a lump sum amount, you will have to report to the IRS a portion of the amount of insurance benefits received in excess of what was actually due at the time of the insured person's death. If you are not given a specific benefit payable amount, you will need to determine the amount paid to you in excess of the present value of the payments made at the time of the insured person's death.
Installments
When you are paid life insurance proceeds by installment payments, you must determine the amount that is contributable to the insurance policy and the amount that is considered interest. You do this by dividing the amount held at the insurance company by the number of installment payments to be made. Any amount paid to you that is over the number determined is regarded as interest and, therefore, reported to the IRS. If the installments will continue for the rest of your life, you will need to determine a figure to represent your life expectancy and use it to divide the amount held by the insurance company.
1986 Exclusion
Surviving spouses, whose partners died before October 12, 1986, and receive life insurance proceeds through installment payments can deduct up to $1,000 per year of related interest from their gross income. Even after remarrying, this surviving-spouse provision continues.
Employer Owned
When you are a business owner holding a life insurance policy on one of your employees and you, or someone related to you, is the beneficiary of the policy, you are liable to pay taxes on any amounts rewarded to you in excess of the premiums or other payments paid into the policy. The following are exceptions to this rule that will allow an employer to exclude the full amount of insurance payments: if the employee provided a written consent to be insured by the employer before the policy is issued; if the employee worked for you within a 12-month period prior to his death or he was a director or highly paid employee; if you opt to provide the proceeds to the family or other designated beneficiary, the entire amount paid is fully deductible.
Surrender for Cash
When you choose to sell, or surrender, your life insurance policy for cash, the amount of money paid to you in excess of what you paid for the policy is taxable. Your cost will include premium payments less any refunded premiums, dividends, rebates or un-repaid loan amounts.
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