Life Insurance✓ Verified · outline & fact-checked · Sep 2026Difficulty 1/5
A beneficiary elects to receive life insurance death proceeds under a settlement option in installments over 20 years, rather than in a lump sum. Under IRC Section 101(a), how are the installment payments treated for federal income tax purposes?
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Answer & full 3-part explanation (select an option above, or peek)
Why C is correct
IRC Section 101(a) excludes life insurance death proceeds themselves from gross income, and that exclusion carries over when the proceeds are paid in installments. However, the insurer pays interest on the funds it retains, and that interest is income to the beneficiary in the year it is received. Each installment therefore splits into a tax-free principal part and a taxable interest part - the key exception to the general rule that lump-sum death benefits are entirely income-tax-free.
Why the other options are wrong
- A) Total exclusion applies only to the proceeds themselves; the interest earned on the money retained by the insurer under a settlement option is taxable income.
- B) Only the interest component of each payment is taxable; the portion representing the death proceeds remains excluded under Section 101(a).
- D) No sale or exchange occurs, so there is no capital gain treatment; the only taxable element is the interest, and it is taxed as ordinary income.
Memory hook
Death proceeds are tax-free money; with installments, only the interest part is taxed.