Health Insurance Taxation

An individual may be an employee or employer so the tax impacts will vary depending on their role in the company. If an employee receives a health insurance policy through the company and the employer pays the premiums, there will not be any tax consequences to the employee. This is one of the unique circumstances where an employee can receive an actual benefit of health insurance while not being taxed on the value paid by the employer. This type of scenario avoids the economic benefit doctrine. Even if the employee and employer split the premium payment, the amount paid by the employee is pre-tax. If the health benefits are used for medical expenses, this is a tax-free benefit.

On the other hand, if the individual is an employer, they can deduct the cost of health insurance coverage as a business expense (Tax Policy Center, 2021). However, if there is an employee who is shopping for an individual plan on the marketplace, the tax situation described above is slightly different. Premiums can be deducted on a health insurance policy for an individual buying a plan through the marketplace given they are not self-employed.

In order to claim this deduction, the amount of unreimbursed medical expenses must be above 10% of AGI for 2021. If a self-employed individual pays a health insurance premium from the business on their own policy, this will be considered taxable income to the owner. The amount paid will then be considered an above the line deduction on the Form 1040. This type of self-employment taxation is only valid if the person’s spouse does not have another health plan through another employer and their spouse’s employer.

Life Insurance Taxation

There are many different variations of life insurance and the tax impacts can vary. Premiums paid for life insurance are typically not taxable nor tax deductible. The one exception is when an employer pays for life insurance on behalf of an employee that exceeds a face value of $50,000. The premium payments are taxed as income to the employee.

Life insurance has another unique benefit in that the death benefits passed to the beneficiary of the policy is typically received tax free. A beneficiary can elect to receive the death benefit as a lump sum (tax free), interest only, or in annuity payments. If the beneficiary elects the annuity option, the portion of the payment received will be classified as interest and principal. The interest earned will be taxable.

The other tax consideration on a death benefit is when the value of the policy will increase the owner’s estate above the federal exemption amount which is currently $11.7 million per person. This will be necessary to evaluate when determining any estate tax risks by including the value of the life insurance policy in the owner’s estate calculation.

Some life insurance policies offer cash value options and these would be considered permanent policies. The cash value in the policy will accumulate over time and grow tax deferred. If the insured would like to distribute the cash value, the IRS treats the distribution as a return of premium paid (FIFO) which is tax free and then anything beyond that amount is considered taxable income (Dong, et. al., 2018).

All premiums paid to date are considered the basis. If any dividends have been received, this will lower the basis by that amount. The cash value distributed will offset the premiums paid until the distribution amount exceeds the premiums paid. Additionally, if a policy is surrendered, the cash value will be returned. If the cash value is larger than the basis (premiums paid), then the difference is considered taxable income.

A life insurance policy can be exchanged into a different type of life insurance policy which is called a 1035 exchange. This allows the deferral of tax from one life insurance policy to another. If the exchange satisfies the rules of the IRS where one policy is exchanged for another similar policy with the same insured, then any gain will be deferred and there will be no tax consequence of the exchange.

Life insurance can be transferred to another owner for value. If an owner does not want to wait for his beneficiary to receive the value upon death, they can sell the policy to another party for a value. The party that purchases the policy will include the death benefit proceeds as ordinary income minus the purchase price (basis) and premiums paid. When a life insurance policy value is transferred to another, it loses the tax-free death benefit. The transfer will lose its tax-free status only if it’s transferred to a third party. The tax status will stay protected if transferred to the insured, a business partner of the insured, a partnership where the insured is a partner, a corporation where the insured is shareholder or through the settlement in a divorce.

A specific type of transfer of value is a viatical settlement. In order for a transfer for value to take place with a viatical settlement, the insured is required to be chronically or terminally ill. When the insured dies, the viatical settlement company will collect the death benefit and the amount above the payment sent to the original policyholder will be taxed as ordinary income. The payment made to the original policy owner plus all premiums paid while they were alive would be considered the basis of the viatical company. The difference between the death benefit received and the basis is taxed as ordinary income. The original policyowner will receive the discounted payment from the viatical company tax free according to the IRS. However, if the policyowner is chronically ill and the proceeds are not used for medical or long-term care costs, the proceeds will be subject to tax. A terminally ill recipient of funds from a viatical transaction has no restrictions on the use of funds for tax purposes.

If the life expectancy of the insured is less than 2 years, some policies offer accelerated benefits. These benefits allow the use of a portion of the death benefit while the insured is still alive. There are no taxes applied to accelerated benefits if life expectancy is less than 2 years.

Disability Benefit Taxation

Disability insurance benefits are tax free if the insured paid the premiums with after-tax dollars. If the premiums are paid with pre-tax dollars such as the employer paying on behalf of the employee, then the disability benefits will be taxable. Additionally, if an employer covers all of the expenses for a group disability policy, the benefits would be taxable and subject to Social Security and Medicare taxes (Investopedia, 2020). This taxation would only apply during the first 6 months of disability. The after-tax premium option is preferred so that all benefits would be tax free. Some group plans will split the premium payments between the employee and employer. In this situation, the portion paid by the employer will be subject to income tax.

Annuity Taxation

The basis of an annuity contract will determine what is taxable. All proceeds that are a return of basis will be tax free because this is considered the contributions the annuitant made during the life of the contract. Anything above the return of basis will be ordinary income charged to the annuitant. Annuities follow the LIFO method which means the gains are distributed first and then the basis.

If the annuity is held in a Traditional IRA or 401(k), it is considered a qualified account and therefore all funds are pre-tax so all distributions from the annuity will be subject to income tax. A non-qualified annuity will have a portion of the balance as the basis and the remainder as the amount gained (Brown, et. al., 1999).

Non-qualified annuity distributions can use the inclusion/exclusion ratio to determine the tax impacts. “The exclusion ratio equals the owner’s investment in the annuity contract divided by the expected return on the annuity. The resulting percentage is multiplied by the distribution, or payment, received to calculate the portion of the payment that is not subject to income tax” (Dalton, et. al, 2020).

Income taxes can be deferred through a 1035 exchange as it was mentioned previously with life insurance taxation. If an annuity has not been annuitized at death, the owner will receive the value of the annuity as part of the estate value. The advantage is that annuities avoid probate and transfer directly to the name beneficiary just like an IRA. Inherited annuity contracts to not receive a step up in basis so the beneficiary will inherit the original basis of the original owner.

References:

Dalton, M. A., Dalton, J. F., & Langdon, T. P. (2021). Insurance Planning – 7th Edition (7th ed.). Money Education.

Disability Insurance Definition. (2020, December 10). Investopedia. https://www.investopedia.com/terms/d/disability-insurance.asp

Brown, J. R., Mitchell, O. S., Poterba, J. M., & Warshawsky, M. J. (1999). Taxing Retirement Income: Nonqualified Annuities and Distributions from Qualified Accounts. National Tax Journal, 52(3), 563–591. https://doi.org/10.1086/ntj41789742

Dong, F., Halen, N., Moore, K., & Zeng, Q. (2019). Efficient Retirement Portfolios: Using Life Insurance to Meet Income and Bequest Goals in Retirement. Risks, 7(1), 9. MDPI AG. Retrieved from http://dx.doi.org/10.3390/risks7010009

How does the tax exclusion for employer-sponsored health insurance. (2021). Tax Policy Center. https://www.taxpolicycenter.org/briefing-book/how-does-tax-exclusion-employer-sponsored-health-insurance-work