Under federal income tax law, a life insurance death benefit paid in a single lump sum to a named beneficiary is generally:
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Answer & full 3-part explanation (select an option above, or peek)
Why B is correct
Under IRC §101(a), life insurance proceeds paid by reason of the insured's death are excluded from the gross income of the beneficiary when received in a lump sum. This exclusion applies regardless of how long the policy was in force or how much was paid in premiums relative to the death benefit. The policyowner's cost basis is irrelevant to the beneficiary's treatment of a death benefit because the proceeds are received by reason of death rather than as a distribution from a living contract. Because the proceeds are an exclusion, the beneficiary pays no federal income tax on the amount and does not report it as income. This is one of the central tax advantages of life insurance and a staple of the licensing exam.
Why the other options are wrong
- A) Death proceeds are not taxed as capital gains when a beneficiary receives them; IRC §101(a) removes the amount from gross income entirely, so no gain is recognized at all in the beneficiary's hands.
- C) Death proceeds are not ordinary income to the beneficiary; §101(a) expressly excludes amounts paid by reason of the insured's death, so the full lump sum is received without income tax.
- D) There is no two-year holding requirement for the exclusion; §101(a) applies from the date the policy takes effect, even during the contestable period. so a one-month-old policy pays the same tax-free death benefit as a thirty-year-old one.
Memory hook
Death proceeds arrive tax-free in a lump sum — §101(a) means the beneficiary keeps the full face amount.