What is the general federal tax treatment of life insurance proceeds paid to a beneficiary?

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

Answer: (C)

When a life insurance policy pays out a death benefit to a named beneficiary, the amount received is generally not subject to federal income tax. This exclusion comes from the tax code, so the beneficiary does not owe income tax on the principal death benefit. If that money is kept and earns interest after it’s received, the interest payments are taxable as ordinary income to the beneficiary in the year they are earned.

There are some edge cases to keep in mind. If the policy is owned by someone other than the insured, or the insured had incidents of ownership at death, the proceeds can be included in the insured’s estate and may face federal estate tax. But for the typical scenario, the principal death benefit itself is not taxed as ordinary income.