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.
Steuer, author of Questions and Answers on Life Insurance: The Life Insurance Toolbook, has more than 25 years of experience and holds the Department of Insurance Analyst License (LA) as well as the Charted Life Underwriter (CLU) designation. Tony holds various leadership positions and has authored three books on the topic of life insurance.
Steuer’s work has been awarded the “Excellence in Financial Literacy (EIFLE) Award from the Institute of Financial Literacy for his The Questions and Answers on Disability Insurance Workbook and The Questions and Answers on Insurance Planner. Forbes named Questions and Answers on Life Insurance: The Life Insurance Toolbook as one of their top nine great investment books.
He’s also the founder of the Insurance Literacy Institute and creator of The Insurance Bill of Rights designed to empower consumers and to identify members of the Insurance Industry dedicated to strong professional standards.