If you've received a payout from an insurance policy, figuring out whether or not to count that money as income can be confusing. Several elements must be analyzed to understand if the benefit is tax-free or fully taxable as ordinary income. The type of policy, the deductibility of premiums and even what the money was used for might all be relevant factors in determining how much of the payout must be counted as income.
Typically, payouts from life insurance policies do not have to be counted as income. Most beneficiaries receive death benefit proceeds free from state and federal income taxes, provided the payout is not greater than the amount of coverage that existed at the time of the insured person's death. For beneficiaries who take a lump sum distribution, the entire payout may be excluded as income. However, if you choose to have the insurance company hold the proceeds in an interest-bearing account, any earnings generated by the original payout must be included in your taxable income for the year. In Publication 525, the Internal Revenue Service instructs recipients of lump sums to report as income only amounts above the policy death benefit.
Payouts you receive from disability insurance must only be included in your taxable income if you received a tax deduction for premiums paid into the policy. HCV Advocate explains that the IRS does not tax both the premiums and the benefits. If you did not deduct disability insurance premiums, benefits are received income tax-free. Only employer-provided disability plans sometimes pay premiums with pre-tax dollars deducted from employee paychecks. Individually purchased policies are usually paid with after-tax dollars from the owner's current earnings or personal savings, so benefits paid from these policies are not counted as taxable income.
Long Term Care Insurance
Long term care insurance is actually considered a type of health insurance, which allows policy owners with eligible contracts to deduct a portion of their premium payments. Benefits received under a tax-qualified long term care insurance plan are usually not considered income. If you don't own a tax-qualified policy, you cannot deduct premiums paid for the coverage. Payouts under both types of plans remain income tax-free provided the benefits you receive are not more than the cost of care. The Texas Department of Insurance warns that taxes may be due on benefits received in excess of the cost of care.
Health insurance policies are designed to pay physicians and medical facilities for care and treatment provided to covered members. Since payment for services rendered comes directly from the insurance company and you never actually take possession of those funds, payouts from health insurance policies are not counted as income. Regardless of how much money a health insurance company pays toward your care, your taxes remain unaffected by the number or size of claims paid on your behalf.
Gregory Gambone is senior vice president of a small New Jersey insurance brokerage. His expertise is insurance and employee benefits. He has been writing since 1997. Gambone released his first book, "Financial Planning Basics," in 2007 and continues to work on his next industry publication. He earned a Bachelor of Science in psychology from Fairleigh Dickinson University.