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    Annuity Payments from Insurance Policy

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    Sarah is age 73 and has a great deal of difficulty living independently, as she suffers from severe arthritis. She is covered by a $400,000 life insurance policy payable upon death, and her children are named as the beneficiaries. Because of her health, Sarah decides to live in a nursing home, but she does not have enough income to pay her nursing home bills, which are expected to total $42,000 per year. As an alternative to payment upon death, the insurance company offers disabled individuals the option of either reduced settlements on their policies or annuity. Given Sarah's age and health, she has the option of receiving $3,200 per month or a lump sum payment of $225,000. To date, Sarah has paid $80,000 in premiums on the policy. How much income must Sarah report if she chooses the lump sum settlement? How much income must Sarah report if she elects the annuity? How much income would Sarah have to report if her nursing home bills amounted to only $36,000 per year?

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    Solution Preview

    Let's take a look at this scenario to determine the tax implications for Sarah.

    She is covered by a $400,000 life insurance policy payable upon death -- this is irrelevant to the situation because she isn't deceased.

    Her nursing home bills are expected to total $42,000 per year.

    She can take 3,200 per month (38,400 per year), or $225,000 as a lump sum settlement.

    She has paid $80,000 in premiums to date. <-- This is the most important part in determining taxable income.

    How much income must Sarah report if she chooses the lump sum settlement?

    To determine this, we need to look at the current tax code. This isn't treated as an annuity payment. The IRS would treat this as a "life insurance policy surrender for cash." Because Sarah is surrendering her policy and she is not terminally ill, it is taxable. If she were terminal, it would be 100% tax-free.

    Here is the IRS regulation:

    If you surrender a life insurance policy for cash, you must include in income any proceeds that are more than the cost of the life insurance policy. In most cases, your cost (or investment in the contract) is the total of premiums that you paid for the life insurance policy, less any refunded premiums, rebates, dividends, or unrepaid loans that were not included in your income.

    Because our scenario doesn't mention dividends, we'll assume she hasn't collected any from this policy. We're working with straight numbers, in that case.

    If she chooses the lump-sum settlement, the calculation is as follows: ...

    Solution Summary

    This solution explains the case of Sarah and the insurance policy, and how much income Sarah must report if she chooses the lump sum settlement or if she chooses the annuity. All questions in the scenario are fully discussed.