Tax treatment of premiums and proceeds

Two tax questions for every health policy

Every accident and health policy raises two tax questions: can the premium be deducted (or kept out of taxable income)? and are the benefits taxable when they are paid? The answers depend on the kind of coverage and, above all, on who paid the premium and with what kind of dollars. The rules come from federal income tax law (Internal Revenue Code sections 104, 105 and 106), so they are the same in every state.

The trade-off rule for disability income

For disability income coverage, remember one idea: the tax break comes once, on the premium or on the benefit, not both.

• Premium paid with after-tax dollars by the insured: benefits are tax-free.
• Premium paid by the employer, or with pre-tax dollars: benefits are taxable income to the employee.

Medical expense benefits work differently: money that reimburses medical care is tax-free either way.

Coverage an individual buys

• Individual medical expense insurance: premiums are a personal expense. They count only toward the itemized medical expense deduction, and only the part of total qualifying medical expenses above 7.5% of adjusted gross income is deductible. Benefits are received tax-free, because amounts received through accident or health insurance for personal injuries or sickness are excluded from gross income.
• Individual disability income insurance: premiums are not deductible. Benefits are tax-free.
• Self-employed people are not treated as employees under these rules. They can generally deduct health insurance premiums for themselves, a spouse and dependents as an adjustment to income, but disability income premiums remain nondeductible and those benefits remain tax-free.

Employer-provided group coverage

• Employer: premiums are a deductible business expense.
• Employee: employer-paid coverage is not taxable income to the employee.
• Group medical benefits: reimbursements for medical care of the employee, spouse, dependents, and a child under age 27 are tax-free.
• Group disability income: benefits are taxable to the extent they come from employer contributions the employee was not taxed on. If the employee paid part of the premium with after-tax dollars, the matching part of the benefit is tax-free. Premiums an employee pays pre-tax, for example through a cafeteria plan, are treated like employer-paid premiums, so those benefits are taxable.

Tax-free even when the employer paid

• Dismemberment benefits paid for the permanent loss, or loss of use, of a body part or function, or for permanent disfigurement, when the amount is set by the nature of the injury and not by time missed from work, such as an accidental death and dismemberment schedule payment.
• Workers' compensation benefits for injury or sickness.

Business uses of disability insurance

• Business overhead expense: premiums are deductible as a business expense; benefits are taxable to the business, which uses them to pay deductible expenses.
• Key person disability and disability buy-sell: premiums are not deductible; benefits are tax-free to the business or the buyer.

Health savings accounts

Employer contributions to an employee's health savings account (HSA) are excluded from the employee's income up to the annual limit. An individual's own HSA contributions are deductible, and withdrawals for qualified medical expenses are tax-free. Withdrawals for anything else are taxable and, before age 65, carry a 20% penalty.

Explain these general rules, but do not act as the client's tax adviser. For a specific situation, refer the client to a tax professional.