Which statement best describes federal income tax liability on life insurance proceeds paid to a beneficiary?

• A. No federal income tax is owed on the life insurance proceeds.
• B. Proceeds are taxed as ordinary income.
• C. Proceeds are taxed as capital gains.
• D. Proceeds are subject to self-employment tax.

Answer: (A)

The key idea is that life insurance death benefits are generally not taxable as income to the beneficiary. Under federal tax rules, the proceeds from a life insurance policy paid out upon the insured’s death are excluded from gross income, so no federal income tax is owed on them. The main exception to this is any interest that may accrue on the death benefit from the time of death to the time it’s paid out; that interest is taxable as ordinary income to the beneficiary. The proceeds themselves aren’t treated as ordinary income, capital gains, or self-employment income, which is why the typical answer is that no federal income tax is owed on the life insurance proceeds.