As a general rule, life insurance death proceeds paid in a lump sum to a beneficiary:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Under IRC Section 101(a), life insurance proceeds received by reason of the insured's death are generally excluded from the beneficiary's gross income. This income-tax-free treatment is a fundamental advantage of life insurance and one of the main reasons the product is used for family protection. If the proceeds are held by the insurer under a settlement option, the interest portion paid to the beneficiary is taxable, but the principal amount remains income tax free. The exclusion applies whether the policy is term, whole life, universal, or group life. This favorable treatment does not change for modified endowment contracts, whose death benefits remain income tax free.
Why the other options are wrong
- Death proceeds are not taxed as ordinary income to the beneficiary under IRC Section 101(a); the exclusion applies to the amount received by reason of death.
- No capital gains tax applies because the death benefit is not a gain realized on a sale or exchange of property.
- The proceeds may be included in the insured's estate for estate tax purposes, but that does not make the death benefit taxable income to the beneficiary.
Memory hook
Death proceeds arrive income-tax free. The interest earned on top, however, is taxable.