 Welcome to this session in which we will discuss the taxation of life insurance proceeds. I say taxation, I'm going to say taxation or lack of taxation of life insurance proceeds. So what is insurance? What is life insurance? Insurance is a form of protection. So how does it work? For example, one individual, the bread winner, usually the person that's working or if two individuals are working, it doesn't matter. Let's assume just for the sake of illustration. This individual is working, he's married and they have two kids and a wife. Here's what's going to happen. This individual, what they would do, they will buy insurance, they will buy insurance for what purpose? In case something happened to the bread winner, in case he passes away, in case he dies, well, the insurance company will provide money to the family so they can pay the rent, pay the mortgage, send the kids to school, so on and so forth. So that's the purpose of insurance. So when a person does pass away, any income received by the beneficiary, who are the beneficiaries, could be the spouse, could be the children, due to the insured person that is considered exempt. Simply put, that money is not taxable, is exempt, provided that the payment is due to what? Due to the death of that individual. So simply put, income received by the beneficiaries, I'm going to call the beneficiaries, I'm going to say bannies, as a result of the insured person is not subject to any taxation, regardless of the bannies relationship that it sees. Now I show you this example where you have a family, but you could have the beneficiaries for any individual or any person, it doesn't have to be a family. The reason I use the family, so it's easier to relate to. So this is what we're going to be discussing in this topic, the taxation of life insurance. So the general rule is, well, guess what, if you receive the premium, I'm sorry, if you receive the proceeds, they are not taxable, but there are other situations. So let's go ahead and discuss those various scenarios. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today. What happened if you cancelled a life insurance policy? So what you did, let's go back to this individual here. This individual here was paying a premium for several years, for four, five years, every year or every month they pay premium, a certain amount. Then suddenly this individual decided to cancel the policy. You are allowed to do that. Here's what's going to happen. When an individual who owns a life insurance policy cancels the policy and what happened is you will receive the cash, the cash surrender value. You must recognize again if the amount received exceeds the premium. You remember you paid money into this insurance policy. We call those payment premiums, premium on insurance policy. Now when you cancel, they're going to give you back money. The money they will give you back might exceed the premium or might be less than the premium. Give the money that they gave you back because there's a cash value. This money is invested. It's greater than the premium. Guess what? You have a gain. If, for some reason or another, the cash surrounded value was lower, maybe they invested it in certain things that did not appreciate in value, then you have a loss. No loss is recognized. Remember the concept here is simple. Your original amount, the one that you invested, is a form of return of capital. And return of capital is not taxable. So you're only taxable if you cancel and receive more than the premium because the premium is considered what? The premium is considered return of capital. They're simply giving you back your money, which is what? Which is tax-free. Now let's discuss accelerated death benefit. What does that mean? When the individual is terminally or chronically ill, it means they have no chance of surviving medically in the near future. What's going to happen is this. You can cash out the policy. Individual could receive accelerated death benefit through the cash surrender or the transfer of the life insurance policy. Any gain from a transaction like this is also executed. Now you have to provide paperwork from your doctor that you are terminally ill or chronically ill. For example, a cancer patient. However, for chronically ill individual, the execution is limited to the amount used specifically for long-term care purposes. In other words, you have to use this money for what? For medical treatment, nursing home fees, or home health services. That's why they allow you to take it out and any gain is tax-free because you need it now. And any portion of the benefit not used for the qualify long-term care purposes, guess what? You are subject to taxation. What else can you do with your life insurance policy? You can transfer your life insurance policy for valuable consideration. Simply put, you can sell it. So when the life insurance policy is transferred in exchange for something of value, the proceeds from the transfer are taxable to the extent that they exceed greater than the amount paid by the policy plus any subsequent premium. Simply put, if you receive more money that you invested, it's a gain. It's a gain. Now it's no longer, you basically use this as an investment. However, there are certain exceptions to this transfer for valuable consideration. Now we're going to just briefly look at the exceptions, but we're not going to worry about them. Just know if it's a buy-sell agreement, what's a buy-sell agreement? Those are typical arrangement between business owners to ensure smooth transition of ownership in the event of that, of specified events. So sometime what happens is you are in a business, you get out, you bring someone, you transfer your life insurance policy to the other individual. What under those circumstances, you know, except there are exceptions to the rule where you don't have to pay taxes if it's part of a tax-free exchange of any type or as a gift. Just know that sometime you might receive, you might transfer, receive return of some sort, but it's not taxable. Just know that generally speaking, it's taxable, but exceptions exist. Now here's what happened when you try to cash out your life insurance policy. I'm going to tell you this. My aunt works in this business. So every time she has a client and the beneficiaries they try to cash out, she will try to convince them to keep the money. Now the money that you receive, let's assume you're going to be receiving a million dollar. My aunt would say, how about you keep the million dollar and we're going to invest this money for you and we're going to give you overall more than a million dollar over the future period. In other words, the million dollar for you is tax-free. How about we invest it for you? Well, if that's the case, the million dollar would remain tax-free. However, the proceeds from this investments are taxable. So investment earning the result from reinvesting life insurance proceeds are subject to tax. Simply put, as if you took the money, went to your brokerage firm or went to your investment firm and you deposited this money that they don't care what it's coming from. It doesn't matter whether it's life insurance or not. What I'm trying to say is usually the insurance company, they will try to tell you to keep it with them. They'll try to convince you. You don't have to. But the point is, you know, they will do a good job convincing you. So if a penny chooses to receive the insurance proceeds and installment, so they will tell you, look, don't take the full money. How about we pay you $35,000 for the next, for each month for the next 20 years? Here the annuity rules applied to determine the taxable portion of each installment payment. And how do we determine the taxable portion? Well, we're going to have to take the payment, the $35,000 and break it down into the original amount under the principal element, which is the principal amount and the interest element because you're going to be earning money on this amount. The principal amount, this amount here will remain tax-free. So let's take a look at this example. Robert was killed in an accident while he was working. Rachel, his wife, received several payments as a result of his death. What is Rachel gross income from the items listed below? The first one is Robert employer paid Rachel an amount equal to three months of salary, which is worth of valued at $50,000, which is the standard practice for all widow and widower, widower of deceased employee. Well, if you work for this company, the policy says, if you die, we're going to give you three months worth of salary. Why? Because you work for us. Well, because you work for us, we are compensating you for compensating you. This amount is taxable. Robert had $15,000 in a crude salary that was paid to Rachel. Well, before he died, he did some work, but he was not paid for that work. Now the company is paying Rachel. Would that be included in the gross income? Of course it is. This 15,000 is form of compensation. Compensation is taxable. Robert employer had provided Robert with a group life insurance of 400,000, which was payable to his widow and the lump sum premium on the on this policy totaling 10,000. So the company included this premium in his gross income. Well, since the company received the money paid to her, it's life insurance policy. The 400,000 is not included at stacks free to Rachel. Robert, he purchased his own life insurance policy, paying 200,000 and paid paid 200,000 that paid half a million in the event of accidental death. The proceeds were payable to Rachel, who elected to receive installment payment as an annuity of 25,000 each year for 25 years. Look, I'm going to tell you this, if she received the payment immediately, the half a million, he said, okay, I want this as a lump sum. It will be tax free since she's going to be receiving payments. So we're going to do, we're going to take 25,000 times 25 years. And if my math is right, this is going to end up to be 625,000. What we do now is we'll take half a million divided by 625,000. So let's do that 500 divided by 625. And that's going to give out a ratio of 80%. What does that mean? It means the payment of 25,000, 80% of it, 80% of the $25,000 payment, which is equal to 20,000 will be tax free. Well, what happened to the remaining, the remaining is, the remaining is 5,000. The $5,000, the remaining $5,000. So of the 25,000, if we determined that 20,000 is tax free, as I showed you in the computation of the 25,000 is tax free, the remaining 5,000 per payment is included in taxable income. What should you do now? Go to Farhat Lectures and look at the additional resources, whether you are a CPA candidate, enrolled agent, gross income inclusion, gross income exclusion is heavily tested on professional taxation exam in your accounting course and your tax course. Good luck, study hard, and of course, stay safe.