Are refunded long term care insurance premiums taxable?

[woods.elise]

Our long term care insurance policy is under a class action law suit and we are given the option to surrender our policy and get all of the premiums we paid since inception as a settlement.   If we elect to choose the settlement option, will the refund be taxable?

[Hal_Al]

Simple answer: no.  Refunds of anything you purchase is not usually considered income. 

But taxes aren't simple. The refund of expenses, that you deducted on previous income tax returns, is considered taxable income. Long term care insurance premiums are deductible, but subject to age based limits.  Furthermore, Long term care insurance premiums, like all medical expenses, are only deductible as an itemized deduction, subject to the 7.5%  (10% some years) of AGI threshold.  So, you may or may not have deducted them (or some of them) in the past

[rjs]

The refund of your long-term care insurance premiums would only be taxable if you included the premiums in the itemized deduction for medical expenses on your tax return for any year that you paid premiums.

If any one of the following three statements is true, none of the refund would be taxable, and you do not have to read any further.

• You always used the standard deduction on your federal tax return, and never claimed itemized deductions for any year that you paid long-term care insurance premiums.
• You claimed itemized deductions, but did not have any deduction for medical expenses for any year that you paid long-term care insurance premiums.
• You claimed itemized deductions, and you did have a deduction for medical expenses, but you did not include the long-term care insurance premiums in your medical expenses for any year that you paid long-term care insurance premiums.

If you did include the long-term care insurance premiums in your deductible medical expenses for any previous year, then the refund would be what is called an "itemized deduction recovery." You would have to report part or all of the refund as taxable income in the year that you receive it. You report only the amount that actually reduced your tax in the earlier year. The calculation of that amount is complicated, and TurboTax will not do it for you. (It could be affected by other things besides the amount of medical expenses you deducted.) You have to do the calculation yourself outside of TurboTax, and enter in TurboTax the taxable amount that you calculate. Adding to the complications, you have to do the calculation separately for each year that you included long-term care insurance premiums in the medical expenses on your tax return. If you had the policy for many years, and included the premiums in your medical expense deduction, this could be quite a lot of work. Also, you need a copy of your federal tax return for each past year that you included the premiums in your medical expense deduction.

You would have the option to report the full amount of the refunded premiums as taxable income, which would save you the trouble of doing the calculations. The IRS will not complain if you do that. But it's probably a significant amount, and there's a good chance that the full amount would not be taxable if you do the calculations.

The rules for calculating the taxable amount that you have to report are in IRS Publication 525, Taxable and Nontaxable Income, in the "Recoveries" section beginning on page 23 (in the 2020 edition).

Since your itemized deduction recovery is for medical expenses, don't forget to take into consideration the fact that your deduction for medical expenses was reduced by a percentage of your AGI. See Example 34 on page 25 in Publication 525.

After you calculate the taxable amount that you have to report as income, you enter it in TurboTax. You should be able to get to the right place by entering "reimbursed deductions" (without the quotes) in the Search box, then clicking the link that says "Jump to reimbursed deductions."

If your state allows a deduction for medical expenses, and you included the long-term care insurance premiums in the deduction on your state tax return in any previous year, you would have to check the rules regarding recoveries for your particular state.

If this is all too overwhelming, or you do not have the information from past years that is needed to calculate how much of the refund would be taxable, you may wish to consult a local tax professional for further guidance.

The information in this reply is specific to the facts given in the question, and might not apply to other situations.

[rjs]

I realized that, in spite of the length of my previous post, I omitted an important consideration. If it applies to you, it could mean that some or all of your premium refund would be taxable, even if you never claimed an itemized deduction for the long-term care insurance premiums, and if the three criteria that I listed in my first reply indicate that none of the refund would be taxable. This would make things even more complicated.

What I overlooked is the possibility that you could have claimed the self-employed health insurance deduction for some or all of the long-term care insurance premiums. If you had self-employment income (business income) on Schedule C or farm income on Schedule F you could have claimed the self-employed health insurance deduction. (Certain less common types of income would also allow you to claim the self-employed health insurance deduction, such as income from a partnership or S corp.) The self-employed health insurance deduction is not an itemized deduction, and you could have claimed it even if you used the standard deduction, or used itemized deductions but did not deduct medical expenses.

If, in any year, you included long-term care insurance premiums in the self-employed health insurance deduction, then the refund of the premiums would be a "nonitemized deduction recovery." You would have to calculate how much of the deducted premiums actually resulted in a reduction of your tax, and report that amount as taxable income in the year you get the refund. The basic concept is the same as for the itemized deduction for medical expenses, but there is no worksheet for nonitemized deduction recoveries. The self-employed health insurance deduction is not subject to the 7.5% or 10% of AGI reduction that applies to the itemized deduction for medical expenses, but the age-based limit on long-term care insurance premiums still applies.

If you never claimed the self-employed health insurance deduction, or claimed it but did not include long-term care insurance premiums in the deduction, you can ignore this whole post.

[rjs]

I made a slight modification to my first reply above. I had originally said that it could not happen that the full amount of the premium refund would be taxable. But thinking it over some more, I realized that there could be circumstances in which the full amount turns out to be taxable. I have modified the answer above accordingly.

[Opus 17]

Long-term care insurance premiums could also have been paid tax-free through an HSA.

The short answer is that the premium refund will only be taxable if you previously received a tax benefit from paying the premiums, such as taking one of the possible tax deductions or paying the premiums with tax free money.  Then, the amount that is actually taxable depends on the “tax benefit rule.“  For example, suppose that last year, you listed $10,000 of premiums as an itemized deduction, but your gross income was $100,000 so that due to the 7.5% rule, you only actually deducted $2500. That’s your tax benefit, so that is the portion of last year’s premiums that would be taxable when they are returned. You will have to do this calculation for every year that you might have included the premiums as a tax deduction or paid for them with tax free money.

[mzdenek]

Last year I received a letter from Genworth a long term care company stating that I have  previously elected a paid up option that required no further premium payments. As part of this settlement I can elect cash payment of $1250.00 and still retain my current paid up benefit. My policy including any reduced benefits associated with the selection of a settlement option, is intended to be a federally tax qualified long term care insurance under Section 7702B of the Internal Revenue code of 1986 as amended. Genworth has stated that it is my responsibility to assess any potential tax consequences of selecting a settlement option, for example whether an cash payment is taxable.

This is what I have read on the letter from Genworth. My question is I have already filed my taxes because I did not realize that I may or may not have to pay taxes on the $1250.00. I guess I was expecting some 1099 form if I received this type of income. Can you tell me if this is taxable for both Federal and State and if it is I will have to file an amended return. Also if this is taxable where in Turbo Tax do I find the section on where to enter this information?   

[MonikaK1]

Whether a lawsuit settlement payout is taxable depends on what the settlement represents. If this is a refund of previously paid insurance premiums, then it is nontaxable unless the amount was previously deducted on your tax return. The taxable amount would be entered in the Other Common Income section or Less Common Income, Miscellaneous Income. 

The principle is the same for both Federal and State returns.

The other posters in this discussion from 3 years ago mentioned correctly that only if you deducted your premiums as medical expenses, in excess of the adjusted gross income limitation, or as self-employed insurance, or they were paid in full through a Health Savings Account, would a refund of the premium be taxable.

If the payout represented something else, such as punitive damages, then it would be taxable and you should have received a Form 1099-MISC. You would enter the information on the form in the Form 1099-MISC section of TurboTax and choose the option for lawsuit settlement when it appears.

See this IRS article for more information about the tax treatment of lawsuit settlements.