Advanced Underwriting Consultants

Ask the Experts – January 3

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers.  Here’s the question of the day.

Question: My client has a life insurance policy with a Critical Illness Rider which pays accelerated death benefits in the case of, for example, a heart attack, cancer, stroke, kidney failure or an organ transplant. Would the proceeds from the critical illness rider be subject to income taxes?

Answer: In most cases, the proceeds will likely be federal income tax-free.

Generally, accelerated death benefits are excluded from gross income under Section 101 as long as the insured is either terminally or chronically ill, but not critically ill. However, the IRS has provided guidance through multiple Private Letter Rulings (see PLRs 200903001, 200627014, 200339016 & 200339015) that the benefits from Critical Illness Riders may nevertheless be excluded from gross income as compensation for injuries or sickness under Section 104(a)(3).

Under Section 104(a)(3), amounts received through accident or health insurance for personal injuries or sickness are excluded from gross income as long as:

      1. The insurance policy premiums are paid with after-tax dollars; and
      2. The amounts received are neither—

a.   Attributable to contributions by an employer which were not includible in the employee’s gross income, or

b.   Paid by the employer

Assuming the amounts received are paid with after-tax dollars and not provided by an employer, the insured shouldn’t incur federal income taxes on the proceeds. However, keep in mind that this proposition comes from IRS Private Letter Rulings, which cannot be relied upon by anyone other than the recipient of the Ruling.

Have a question for the professionals at AUC?  Feel welcome to submit it by email.  We may post your question and the answer as the question of the day.