Which statement best describes the tax treatment of life insurance death benefits when paid to beneficiaries?

Which statement best describes the tax treatment of life insurance death benefits when paid to beneficiaries?

• A. They are generally tax-free to beneficiaries; any interest earned on proceeds during the settlement may be taxable.
• B. They are always taxed as ordinary income.
• C. They are subject to capital gains tax.
• D. They are exempt only if the policy is MEC.

Answer: (A)

The main concept is that life insurance death benefits paid to beneficiaries are generally not taxable as income. When the policy pays out in a lump sum, the amount received is typically tax-free to the beneficiary. If the payout is distributed over time or sits in an interest-bearing arrangement, the interest that accrues on those proceeds can be taxable as ordinary income to the beneficiary as it earns. Also, the Modified Endowment Contract status does not change this rule about death benefits being tax-free; it mainly affects the tax treatment of cash value distributions during the insured’s life, not the death benefit itself. So the correct statement captures the general tax-free nature of death benefits with the caveat that any interest earned on the proceeds during settlement may be taxable.

The main concept is that life insurance death benefits paid to beneficiaries are generally not taxable as income. When the policy pays out in a lump sum, the amount received is typically tax-free to the beneficiary. If the payout is distributed over time or sits in an interest-bearing arrangement, the interest that accrues on those proceeds can be taxable as ordinary income to the beneficiary as it earns.

Also, the Modified Endowment Contract status does not change this rule about death benefits being tax-free; it mainly affects the tax treatment of cash value distributions during the insured’s life, not the death benefit itself. So the correct statement captures the general tax-free nature of death benefits with the caveat that any interest earned on the proceeds during settlement may be taxable.