A California resident beneficiary elects to receive a life insurance death benefit in equal annual installments rather than a lump sum. For California personal income tax purposes, the installment payments are treated as:
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Under IRC Section 101(a), the death proceeds themselves remain excluded from income even when the beneficiary elects to receive them in installments, but the interest element credited on the unpaid balance is taxable as ordinary income. California personal income tax law conforms to the federal treatment of installment settlements, so a California resident beneficiary applies the same rule: the principal portion representing the death benefit is tax-free, while the interest the insurer pays on top is includable in California taxable income. The beneficiary must therefore separate the excluded principal from the taxable interest for the entire payout period, and the same principle governs interest-only settlement options.
Why the other options are wrong
- B) Installments are not fully tax-free; the exclusion covers the principal portion only, while the interest the insurer earns and pays on the unpaid balance is ordinary taxable income. so the full amount cannot escape tax.
- C) The payments are not fully taxable — the portion representing the original death proceeds remains excluded under §101(a), so only the interest element is included in income. The principal never becomes taxable.
- D) Interest on installment settlements is ordinary income, not capital gain, and the principal is excluded rather than taxed in any year. Ordinary income treatment is the only correct characterization.
Memory hook
California follows the federal split: proceeds stay tax-free, only the installment interest is taxed.