In this video, we walk through 5 REG practice questions demonstrating how to calculate gifts and life insurance proceeds excluded from gross income. These questions are from REG content area 4 on the AICPA CPA exam blueprints: Federal Taxation of Individuals.
The best way to use this video is to pause each time we get to a new question in the video, and then make your own attempt at the question before watching us go through it.
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How to Calculate Gifts and Life Insurance Proceeds Excluded From Gross Income
Certainly, understanding how specific types of income are treated for tax purposes can significantly impact financial planning. Let’s delve into the two topics you mentioned: gifts received and life insurance proceeds, including specific rules and exceptions.
Gifts Received and Exclusion from Gross Income
In general, gifts received by an individual are not included in the recipient’s gross income. This means that if someone gives you a gift, whether it’s cash, property, or any other type of asset, you do not have to include the value of that gift as income on your tax return. It’s that simple.
Additional Note:
The annual exclusion and the lifetime limit do not apply to recipients of gifts, only to givers. So, for the purposes of this post, we will not go over the annual exclusion and the lifetime limit in detail, but know that they do exist.
Receiving a Gift Example:
Scenario: Imagine your aunt decides to give you $15,000 as a graduation gift.
Tax Implications:
- Since the gift is below the annual exclusion limit for the year (which, for example, might be $16,000), neither you nor your aunt would have to report this gift to the IRS.
- You, as the recipient, do not need to include this $15,000 in your gross income for tax purposes. It’s completely tax-free to you.
- Your aunt does not owe any gift tax on this amount because it’s under the annual exclusion threshold.
Life Insurance Proceeds and Exclusion from Gross Income
Generally, life insurance proceeds received by beneficiaries upon the death of the insured are not included in gross income and therefore are not taxable. This provides a significant financial benefit to beneficiaries, ensuring that they receive the full amount of the intended support without a tax reduction.
Key Points:
- Exclusion Rule: The death benefit of a life insurance policy is typically excluded from the beneficiary’s gross income. This applies regardless of the size of the policy.
- Trade for Value Rule: However, there’s an exception known as the “trade for value rule.” If a life insurance policy is sold to another party before the insured’s death (a situation known as a life settlement), the death benefit may be partially taxable to the buyer. Specifically, any amount received over the price paid for the policy plus any subsequent premiums paid by the buyer is taxable.
- Interest Payments: It’s important to note that while the life insurance death benefit is not taxable, any interest received as part of the insurance proceeds (for example, if the payout is delayed and accrues interest) is taxable as income.
Life Insurance Proceeds Example:
Scenario: After your grandfather passes away, you are named the beneficiary of his life insurance policy, which has a death benefit of $100,000. Instead of taking a lump sum, you opt for a settlement option that pays out the $100,000 over 5 years, plus interest. The insurance company informs you that you will receive $21,000 each year for 5 years, which includes $1,000 per year in interest.
Tax Implications:
- The principal amount of the life insurance proceeds ($100,000) is not taxable and is excluded from your gross income.
- However, the interest portion ($1,000 annually) is considered taxable income. You must report this $1,000 each year on your tax return as “Interest Income.”
