A beneficiary elects to receive life insurance death proceeds in equal installments over 20 years instead of a lump sum. Which portion of each installment is taxable?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
When death proceeds are paid in installments rather than in a lump sum, the principal portion of each payment retains its IRC Section 101 exclusion, but the interest earned on the proceeds held by the insurer is taxable as ordinary income. The beneficiary receives a blend of tax-free principal and taxable interest. This is the key exception to the general rule: the death benefit itself stays income-tax-free, while the interest it generates does not. The longer the payout period, the more interest accrues and the larger the taxable component of each installment.
Why the other options are wrong
- B) The entire installment is not taxable because the principal portion retains the IRC Section 101 exclusion. Only the additional interest earned on the retained proceeds is included in income.
- C) The principal is the tax-free component of each installment. It is the return of the death proceeds, which are excluded from gross income under Section 101, and it is the interest, not the principal, that carries the tax.
- D) Part of each installment is taxable. The interest element that the insurer pays for the privilege of holding the proceeds is ordinary income to the beneficiary, so a totally tax-free installment would ignore this interest element.
Memory hook
Installments = tax-free principal plus taxable interest. The extra money the insurer pays you is taxed.