Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 2/5
A death benefit of $200,000 is paid to a beneficiary in 20 equal annual installments. For federal income tax purposes, the 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 death proceeds are generally excluded from the beneficiary's gross income when paid as a lump sum. When the proceeds are instead paid under a settlement option in installments, the principal is recovered tax-free in proportion, but the interest element of each payment is taxable as ordinary income. The beneficiary reports only the earnings on the deferred principal, never the $200,000 death benefit itself. This mirrors the annuity exclusion-ratio principle under IRC Section 72.
Why the other options are wrong
- B) Taxing the full amount of each installment would tax the death benefit principal, which Section 101 exempts.
- C) The interest earned on the principal while payments are deferred is not exempt simply because the insured died.
- D) Interest is taxable on each installment, not only on the last one.
Memory hook
Principal is tax-free forever; the interest it earns is not.