Can You Claim a Dependent Who Cashed Out a Life‑Insurance Policy?

IRS rules on claiming a dependent who cashes out a life‑insurance policy

You can still claim a dependent who has received a cash‑out from a life‑insurance policy, provided the cash‑out does not make the dependent a qualifying child or relative for tax purposes. The key factor is whether the dependent meets the IRS's definition of a qualifying dependent at the end of the tax year.

Qualifying dependent criteria

The IRS requires that a dependent be a U.S. citizen, resident alien, or a resident of Canada or Mexico, and that the taxpayer provide more than half of the dependent's support. The dependent must also meet one of the following: a qualifying child (relationship, age, residency, joint return test) or a qualifying relative (relationship, gross income limit, support test). A cash‑out from a life‑insurance policy is considered income to the dependent, but it does not automatically disqualify them.

Impact of the cash‑out on the income test

For a qualifying relative, the dependent's gross income must be less than the exemption amount ($4,400 for 2022, adjusted annually). If the cash‑out pushes the dependent's total income above that threshold, the dependent no longer qualifies as a relative. However, if the dependent also satisfies the qualifying child tests (especially the age and school‑attendance requirements), the income test does not apply.

Support test considerations

The support test requires that you provide more than 50 % of the dependent's total support for the year. When a life‑insurance cash‑out is used by the dependent, it counts as part of their support. You must still cover the majority of their expenses—housing, food, education, medical care, etc.—to meet the support requirement.

Practical steps to determine eligibility

• Calculate the dependent's total gross income, including the life‑insurance payout.
• Compare the amount to the current exemption threshold.
• Assess whether you provided over half of the dependent's total support.
• Verify that the dependent meets either the qualifying child or qualifying relative tests.

When the dependent becomes ineligible

If the cash‑out raises the dependent's income above the exemption limit and they do not meet the qualifying child criteria, you cannot claim them. In that case, you may still be able to claim a dependency exemption for a different qualifying relative or claim other credits (e.g., Child Tax Credit) if other conditions are met.