OK, we lied. This article has nothing to do with sex. But how else could we get you to read about insurance and taxes? And read about them you should, since they're a part of all our lives. (As for sex, well, you weren't brought here by a stork.)

Our discussion will focus mostly on individual taxpayers who don't use the insurance for business purposes. For example, we'll discuss property insurance in just a few more paragraphs, and will tell you that it's not deductible on your tax return. However, if you're using the property on which the insurance is attached as a business or rental property, the premiums are deductible as a business or rental expense. But, in order not to confuse, we'll generally limit our discussions to individuals with no business interests.

So without further chatter, let's get started...

Property or homeowner's insurance: This is the insurance that you purchase to protect your home against unforeseen casualties. The premiums paid for your property insurance are not deductible for the non-business property. But should you ever be required to cash in a claim from this insurance for damages to your property, the proceeds are generally not taxable to you.

Auto insurance: Just like property insurance, the premiums for auto insurance are also not deductible for non-business auto usage. If you do use your auto for business, and elect the "actual method" for computing your auto expense deduction (as opposed to the "cents per mile method"), some or all of your premiums may be deductible. But for the average non-business taxpayer, who uses his auto for personal purposes only, there is no deduction. Any claims that you receive from the insurance company to repair or replace your auto due to theft or damage are generally not taxable to you.

Term life insurance: No deductions for premiums paid here for non-business taxpayers. The premiums that you pay are purely personal and non-deductible. The good news (at least for your life insurance beneficiary) is that the insurance proceeds received by your beneficiary are not taxable income. The bad news for you is that you have to pass on for you beneficiary to receive this windfall. But while the insurance proceeds will not be taxable to your beneficiary, they will be included in your estate for estate-tax computations. So you'll want to make sure that your estate (including insurance proceeds) are under the current estate-tax limitations. If they are not, there are various steps (such as an irrevocable life insurance trust) that you can utilize in order to keep the estate tax proceeds both free from taxes for your beneficiary and excluded from your estate.

Cash-value life insurance: Again, the premiums for this insurance are not deductible for non-business taxpayers. Remember that with cash-value life insurance and its variants -- namely, whole life, variable life, and universal life insurance -- you are actually making TWO payments: one for your life insurance coverage and another for the investment portion of the contract (the earnings of which accumulate tax-free). The longer you pay on this account, the more it creates a "cash surrender value" for you. This means that if you surrender the contract, you can receive your cash back for the investment portion of the prior payments (you'll never receive your insurance premiums back).

If you decide to take the money and run, you'll have to know exactly what you paid into the investment portion of the contract. Many insurance companies will keep track of your cost basis in the investment side of a cash-value policy, but many still do not -- especially for policies 20 or 30 (or more) years old. As with term life, the proceeds of a cash-value life insurance policy are not taxable to the beneficiary, but the value of the insurance and investment component are included in the value of your estate for estate-tax purposes.

Disability insurance: This one can get a little tricky, even for non-business taxpayers. In many cases, your employer will allow you to purchase disability coverage through payroll deductions. And some employers even allow for the purchase of this disability insurance through a cafeteria or other tax-favored payroll or benefit plan. Generally speaking (and I emphasize the word "generally" -- your mileage may vary so check with your benefits folks if you are receiving disability coverage under an employer cafeteria or benefit plan) it works like this:

• If you pay the disability premiums with your after-tax dollars, the premiums are not deductible to you. Additionally, if you receive any disability benefits, they will not be treated as taxable income. This makes sense, since you didn't receive a tax deduction when you paid the premium, so why should you be penalized with taxable income when the policy pays off?
  
  
• If you pay the disability premiums with pre-tax dollars (such as through a cafeteria plan or other pre-tax employer plan), the premiums are not deductible, since the dollars that you used to pay the premiums were not treated as taxable income. But if you receive benefits, those benefits will generally be taxable to you. Again, it's a two-edged sword: Since pre-tax money paid for the premiums, you'll have to recognize taxable income when you receive any benefits.
  
  
• If your employer pays the disability benefits on your behalf, and doesn't tax you on the premium payments made to the insurance company, you're receiving a tax-free fringe benefit.
  
  
• If you're required to pay for coverage as mandated by a state government, these payments are generally made on an after-tax basis, which would make any benefit received not subject to income taxes.

Again, disability payment issues can get very tricky. If you have a disability plan at your place of employment, it might be worth you while to bug your benefits folks in order to understand exactly how that disability plan works, and if any of the benefits would be taxable to you should you be unfortunate enough to have to make a claim.

Health insurance: The premiums paid for health insurance are treated as an itemized deduction for medical expenses for non-business taxpayers. But don't get too excited. In order to reap any tax savings from these premiums, you'll have to itemize your deductions. And even if your do itemize, only that amount of premiums (and other medical expenses) in excess of 7.5% of your adjusted gross income will be allowable as your actual tax deduction. So most of us are unable to avail ourselves of this deduction. If you receive health insurance as part of your benefits package, or even if you pay them with after-tax dollars, the benefits paid by the insurance company are not taxable to you.

Long-term care insurance: Premiums that you pay for qualified long-term care insurance qualify as an itemized deduction for individual income tax purposes, subject to the same 7.5% AGI restriction. And, as with health insurance, benefits that you receive under a long-term care plan are not taxable to you, even if your employer pays the premiums.

Excess liability or "umbrella" insurance: The premiums for these types of plans are not deductible for non-business individuals. But again, any benefits received under these types of policies are not included as taxable income.

Business interruption insurance: This is a type of insurance that generally pays benefits to compensate for lost income or profits should a business be unable to continue operations due to some unforeseen circumstances. While these premiums are generally deductible by the business owner, any benefits received are subject to income tax.

As you can see, the general rule of thumb is that there is no rule of thumb. You can take the view that if you receive a tax benefit for the premiums paid, then you'll get hit with taxable income when you receive benefits. This is true in some, but not all, cases. So make sure that you understand the terms and benefits of your specific policy and coverage. If you need help, make sure to speak with an insurance professional, a tax professional, or your employer's human resources department.

And if you want to learn more about insurance in general, visit The Motley Fool's Insurance Center.

Related Links:
The Motley Fool's Insurance Center
Deductions -- An Overview

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

September 13, 2002

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