There are certain tax consequences that come from getting a monetary settlement which need to be addressed when preparing your annual income tax return. Policyholders eligible for compensation are usually given several options – depending on their life insurance company. The tax ramifications will also depend on the method you choose.
It is advised to discuss this with your tax advisor.
On most life insurance policies, except for Modified Endowment Contracts, any amount taken from a policy, up to the amount of premiums paid in (your basis), is received income tax free; any amount received after that is subject to income tax (treated as gain).
Policyholders eligible for compensation in a class action lawsuit may be offered several options.
For example, three “relief choices” are available for policyholder eligible for class action settlements.
Two types of “basic claim relief” and a refund of premiums (with interest) are also offered. There could be taxable money involved in each of these choices. If you opt for a return of premium with interest, the premium is not subject to taxes, but the interest would be.
For other settlement options, distributions from a life insurance policy are not taxable until you’ve received more money than you paid in premiums. Any amount above that is taxed at the ordinary income tax rate.
If you take a settlement from a life insurance company due to a lawsuit, the company will send you an Internal Revenue Service (IRS) Form 1099. This form shows whom you received income from and how much.
Therefore, the IRS will know that you received this money and will match it up with your tax return as well as gross earned income, which is fully taxable.
The insurance company should also provide you with a document showing how the amount of the settlement breaks down, which allows you to pay taxes only on the amount above the sums of your premium paid, if applicable.
These forms are required to be sent by the insurance company by January 31st of the year your tax is due.
You will receive either a Form 1099 MISC, which applies to miscellaneous income and shows the total amount you received or a Form 1099 INT, which list the interest payment of your premium that you received.
This can be confusing, which is why it is advised to seek out the assistance from a qualified tax advisor.
By Tony Steuer, CLU, LA, CPFFE
Tony Steuer is an author and advocate for financial preparedness. Tony Steuer, CLU, LA, CPFFE, helps people make sense of the financial world in a way that’s easy for them to understand. His books including, “GET READY!,” “Insurance Made Easy,” and “Questions and Answers on Life Insurance,” have won numerous awards. Tony is the founder of the GET READY! Initiative which includes the GET READY! financial organization system, the GET READY! Financial Preparedness Club, GET READY! Podcast, and the GET READY! Financial Principles, a best practices playbook for the financial services industry. Tony served as long-term member of the California Department of Insurance Curriculum Board. Tony is regularly featured in the media including the New York Times, the Washington Post, Fast Company, and other media. He has also appeared as a guest on television shows, such as ABC’s “Seven on Your Side.” Visit https://tonysteuer.com/ to join the GET READY! Financial Preparedness Club and access free resources.