J.K. Lasser's Your Income Tax 2013: For Preparing Your 2012 Tax Return

11.19 A Policy With a Family Income Rider

Payments received under a family income rider are taxed under a special rule. A family income rider provides additional term insurance coverage for a fixed number of years from the date of the basic policy. Under the terms of a rider, if the insured dies at any time during the term period, the beneficiary receives monthly payments during the balance of the term period, and then at the end of the term period, receives the lump-sum proceeds of the basic policy. If the insured dies after the end of the term period, the beneficiary receives only the lump sum from the basic policy.

When the insured dies during the term period, part of each monthly payment received during the term period includes interest on the lump-sum proceeds of the basic policy (which is held by the company until the end of the term period). That interest is fully taxed. The balance of the monthly payment consists of an installment (principal plus interest) of the proceeds from the term insurance purchased under the family income rider. You may exclude from this balance a prorated portion of the present value of the lump sum under the basic policy. The lump sum under the basic policy is tax free when you eventually receive it.

The rules here also apply to an integrated family income policy and to family maintenance policies, whether integrated or with an attached rider.

In figuring your taxable portions, ask the insurance company for its interest rate and the present value ...