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Discuss taxability of insurance proceeds

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.

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.