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Discuss taxability of insurance proceeds

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Joe owes Willy $5,000 from an old gambling debt. Joe knows that there is no
way he can repay the debt in the near future. He asks Joe if he will take a
$25,000 life insurance policy that has a cash surrender value of $4,200 and
release him from the debt. Willy agrees to take the insurance policy and cancels
Joe's debt. Willy makes only one premium payment on the insurance policy
of $50 when Joe is killed in an auto accident. Willy collects the $25,000.

Explain all the tax consequences of these events for both Joe and Willy.

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Solution Preview

For gambling income, if the individual gives their social security number, then the estimated tax is 25%, if no SS number is given the nominal rate that must be withheld is 28%. The actual tax rate maybe as high as 35%, depending upon the individual's income situation.

To begin with Willy should have sent in a payment on a W2G of 25% of the gambling debt that was settled for $4,200, so Willy should have sent in $1,125 estimated tax.

However Willy did not pay in the estimated tax, and he made a payment on the policy of $50 dollars, therefore his net winning at that point were $4,200 - $50, $4,150, so 25% estimated tax of $1,037.50.

Before Willy can pay the tax Joe dies, and the insurance pays out $25,000. The ...

Solution Summary

The expert discusses taxability of insurance proceeds. Tax consequences of the events are determined.