Which statement is true about life insurance proceeds for federal income tax purposes?

Which statement is true about life insurance proceeds for federal income tax purposes?

• A. They are generally income tax-free to the beneficiary
• B. They are always taxed as ordinary income
• C. They are always subject to estate tax
• D. They are taxed only if dividends are included

Answer: (A)

Life insurance death benefits are generally income tax-free to the beneficiary. The IRS excludes the payout from the recipient’s gross income, so the beneficiary typically won’t owe federal income tax on the death benefit itself. There are a couple of important nuances. If the proceeds aren’t paid out all at once and instead earn interest while awaiting payment, that interest is taxable as ordinary income to the beneficiary. Also, while the death benefit itself is usually not subject to income tax, it can be included in the insured’s gross estate for estate tax purposes under certain ownership scenarios, which is a separate tax consideration. So the statement reflects the standard income tax treatment: the death benefit is generally not taxed as income for the beneficiary.

Life insurance death benefits are generally income tax-free to the beneficiary. The IRS excludes the payout from the recipient’s gross income, so the beneficiary typically won’t owe federal income tax on the death benefit itself.

There are a couple of important nuances. If the proceeds aren’t paid out all at once and instead earn interest while awaiting payment, that interest is taxable as ordinary income to the beneficiary. Also, while the death benefit itself is usually not subject to income tax, it can be included in the insured’s gross estate for estate tax purposes under certain ownership scenarios, which is a separate tax consideration.

So the statement reflects the standard income tax treatment: the death benefit is generally not taxed as income for the beneficiary.