Many people take out a life insurance policy upon a relative such as an aunt or uncle and pay the premiums for years with the expectation that the insured will die eventually and they will collect the life insurance proceeds. The problem is that such life insurance proceeds are taxable or at least the gain is taxable. The second problem is that of determing the cost or premiums paid over the years. This gain is NOT a capital gain but is ordinary income. See Revenue Ruling 2009-13.
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Why?
Why is it taxable? Is it because you are paying the premiums and not the person who is insured?
Linda, EA -
Most companies would not issue such a policy unless there is an insurable interest. In other words, what economic loss would the purchaser suffer upon the insured's death? Of course, one could purchase such a policy already in existence by paying the CSV or other negotiated amount to the insured, in exchange for being named owner and beneficiary. You said many people do this, but in my experience, it is generally rare. In addition, Revenue Ruling 2009-13 rules on the surrender, redemption or maturity of contracts, not the payout as death benefits. There are some companies who deal in these, called viaticals. In the case of payout at death, the death benefit would be tax-free.Last edited by Burke; 09-13-2011, 10:03 AM.Comment
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No different than immediate family?
Burke, let me see if I understand you correctly on 2009-13. The taxation is on the difference between the cash surrender value and the invested premiums, and NOT on the entire proceeds, right? And it is ordinary income, as Dyne says.
If this be true, I see no difference between this and a policy on one's spouse. Except for the timing. In the latter case, as soon as the accumulated cash value exceeds the invested premiums, the policy holder receives a 1099-INT for the difference every year. Since he is paying tax on the excess accumulation every year, his "basis" in the policy becomes the new cash value. There is no tax upon death because he has already been taxed on the accumulated gain. And it is ordinary income.
Just like the guy in Dyne's post, assuming he has an insurable interest. Except this guy does not incur income every year, he waits until death and pays on the entire accumulated difference.
Do I have this interpreted right? or have I done a poor job in explanation...Comment
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In my experience going back many years and listing personal living expenses of taxpayers I encountered many people who were paying weekly to an insurance collector upon a life insurance policy for a relative. It may not be as common now.Comment
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I recall that many of these people had life insurance policies on SEVERAL relatives which made me think of the lottery. I do not know if they purchased the life insuance policy directly from the life insurance company or possibly from the original owner of the policy. In doing further research I found websites which said that such life insurance proceeds should be reported on lines 16a and 16b of page 1 of the tax return as ordinary income. Another website said that under some conditions the proceeds could be considered to be long term capital gains.Comment
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If proceeds are paid to the named beneficiary upon the insured's death, they are not considered taxable income to that beneficiary. (They may be reported on an Estate Tax Return, Form 706 for the deceased and subject to estate taxes in some cases). If the policy is surrendered for its cash value during the insured's lifetime, and that CSV exceeds the net premiums paid in (basically), then the difference is taxable income to the owner who receives those proceeds. It is treated somewhat like an investment gain. Likewise, if at some point -- for a mutual life insurance company that pays "dividends" on its policies -- those dividends begin to exceed the total premiums paid in, then from that point on the dividend may be taxable to the insured or owner, whoever receives it. Up until that point, they are considered a return of premium, and not reported on the 1040. The insurance company will let you know when that happens. Note that most mutual companies have demutualized, and the taxable dividends they now pay are on their stock and not from the policy itself. There are some more complicated situations, like life insurance contracts which are classified Modified Endowment Contracts, and which allow lump-sum payments in excess of required premiums. It was the advent of these in the 80's I think, that prompted the IRS to issue a regulation on the taxation of such policies which applies the same sort of rule to annuities. And, yes, any taxable payment is ordinary income.Comment
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One correction. If you are received a 1099-INT, it is because dividends have been left to accummulate inside the contract, and they are earning taxable interest, just like a savings account. This could happen long before the dividends exceed the premiums. And those can be withdrawn at any time, just like a savings account. Once the dividend itself has exceeded the net premiums, then you would receive a 1099-R for the taxable portion.Originally posted by Nashville;Last edited by Burke; 09-13-2011, 12:59 PM.Comment
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Industrial Policies
These were the old "industrial" policies. In terms of today's economy, they would be considered an incredible dinosaur. Insurance agents would drive into milltown and factory tenements to collect as little as $1.50 per week or maybe $4.00 per month or even less. Some of them were even robbed before they got outa there. The eventual proceeds were usually just barely enough to bury the policyholder.
With a structure such as the above, the price of the policy had to be high enough to accommodate not only the cost of coverage but also the concomitant costs of administration and collection, which far exceeded the sinking fund to cover burial.
As this is obviously uneconomical to survive in modern times, actually pre WWII almost all life insurance was carried on these industrial policies. In fact, in Nashville, industrial policies were the lifeblood of two life insurance company giants, National Life and Life & Casualty, who competed for the tallest buildings in town and massive financial holdings. National Life actually owned the "Grand Ole Opry" and the radio station and everything that came with it. Both of these companies are now absorbed into the huge American General out of Houston which staged hostile takeovers in the 1980s.Comment
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"A man that holds a cat by the tail learns something he can learn no other way." - Mark TwainComment
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Linda was right and I was wrong. Pub 17 and the TaxBook both say that life insurance proceeds paid to you because of the death of the insured person are not taxable unless the policy was turned over to you for a price. I imagine that would be rare. Thanks.Comment
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Rare, but it happens, maybe more often in business situations. And in those cases, there well may be taxable income even on the death of the insured. Give Revenue Ruling 2009-14 a thorough reading to see cases in which the purchase of an existing term insurance policy from the original owner where there is no insurable interest constitutes an action for profit, and it incurs taxable ordinary income when proceeds are paid at death, as well as capital gain treatment to the seller upon the sale. Perhaps this is what you were thinking of.Comment
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