Is Critical Illness Cover a Taxable Benefit?
Learn how tax applies to critical illness cover, including the rules for employer-paid premiums and the long-term impact a payout has on your estate.
Critical illness cover is a form of insurance that provides a one-time, lump-sum payment if the policyholder is diagnosed with a serious medical condition specified in the policy. These conditions often include illnesses like cancer, heart attack, or stroke. The financial payout is intended to help cover costs that traditional health insurance may not, such as lost income, modifications to a home, or experimental treatments.
Tax Treatment of Premiums
The taxability of critical illness cover begins with who pays the premiums. When an employer pays for an employee’s policy, the premium’s value is considered a taxable fringe benefit. This amount is treated as “imputed income” to the employee and must be included in their gross income for the year.
The value of the employer-paid premium will appear on the employee’s annual Form W-2. This additional income is subject to federal income tax, as well as Social Security and Medicare taxes, collectively known as FICA taxes.
In contrast, if you purchase a policy with your own after-tax dollars, you cannot deduct the premium payments on your personal income tax return. While there is no upfront tax deduction, this payment method is what allows a future payout to be treated as tax-free.
Some employers offer plans through a cafeteria plan under Section 125, allowing employees to pay premiums with pre-tax dollars. This reduces current taxable income, but it also means that any benefits received from the policy will be considered taxable income.
Tax Treatment of the Payout
A key aspect of critical illness insurance is the tax treatment of the payout. The lump-sum payment is typically received free from federal income tax, provided the premiums were paid with after-tax dollars. This happens when an individual pays for the policy themselves, or when an employer-paid premium is included in the employee’s taxable income. The benefit is not considered income, but a payment from a health insurance policy.
If the premiums were paid on a pre-tax basis, such as through an employer’s cafeteria plan, the tax outcome changes. In this scenario, any benefits received are considered taxable income. A tax benefit was already received by paying premiums with pre-tax money, so the subsequent payout is subject to tax.
Inheritance Tax Implications
While a critical illness payout is free from income tax, it can have consequences for federal estate taxes. Once the lump-sum payment is received, it becomes part of the individual’s personal assets. If the policyholder passes away, this cash is included in the total value of their estate.
If this infusion of cash, combined with other assets like property and investments, pushes the total value of the estate above the federal estate tax exemption, the excess amount could be subject to estate tax. The federal exemption is $13.99 million per person for 2025, but this amount is scheduled to decrease significantly in 2026.
A strategy to prevent the insurance proceeds from being included in a taxable estate is to place the policy within an Irrevocable Life Insurance Trust (ILIT). An ILIT is a legal entity created to own the insurance policy. The trust is named as the beneficiary, and a trustee is appointed to manage the funds on behalf of the ultimate beneficiaries, such as the policyholder’s children.
By structuring ownership this way, the policyholder never legally possesses the payout. The proceeds are paid directly to the trust and are not considered part of the individual’s estate upon their death. This ensures the full benefit is preserved for the intended beneficiaries without being diminished by federal estate taxes.