A beneficiary elects to leave the life insurance death proceeds with the insurer and receive them under a settlement option that pays principal and interest in installments. For federal income tax purposes, these installment payments are:
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Answer & full 3-part explanation (select an option above, or peek)
Why C is correct
Under IRC Section 101(a), life insurance proceeds paid by reason of the insured's death are excluded from gross income, and that excluded character carries over to the principal portion of each installment when proceeds are paid under a settlement option. However, interest credited on the proceeds after death is not paid by reason of death; it is investment earnings, so the interest portion of each payment is taxable as ordinary income to the beneficiary. This is the key tax distinction between a lump-sum payment, which is entirely excludable, and an interest-bearing settlement option.
Why the other options are wrong
- A) The exclusion covers the death benefit itself, not the post-death earnings on it; the interest component is taxable income in the year received.
- B) The principal portion retains its excluded character under IRC Section 101(a); only the earnings portion is included in gross income.
- D) No sale or exchange occurs, and the interest component is ordinary income rather than capital gain; the installment character of the payments does not convert it.
Memory hook
Death benefit = tax-free money to the beneficiary. The IRS sits that one out.