If a life insurance policy has a beneficiary who has just received a claim payment, which statement about federal income tax liability is true?

• A. No federal income tax is owed on life insurance proceeds
• B. Proceeds are taxable as ordinary income
• C. Proceeds are deductible
• D. Proceeds are subject to estate tax

Answer: (A)

Life insurance death benefits paid to a named beneficiary are generally income-tax free. The IRS doesn’t treat that payout as ordinary income to the recipient, since it’s a payout for the insured’s death, not earnings. The only tax that can apply is if interest accrues on the death benefit after the insured’s death; that interest is taxable as ordinary income to the beneficiary. Estate tax is a separate consideration and applies to the value of the policy if the policy is owned by the decedent at death and part of the estate, not to the income tax liability of receiving the benefit. So the statement that no federal income tax is owed on life insurance proceeds is true. Proceeds aren’t deductible, and they aren’t generally taxable as ordinary income, except for any interest portion, while estate tax concerns are separate from income tax.