Under an interest-only settlement option, the insurer holds the death proceeds and pays the beneficiary periodic interest. The interest payments the beneficiary receives are:
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Answer & full 3-part explanation (select an option above, or peek)
Why B is correct
In an interest-only settlement, the insurer retains the death proceeds as principal and pays the beneficiary interest on them over time. IRC §101(a) excludes the principal (the death proceeds) from income, but the interest credited and paid is ordinary taxable income to the beneficiary in the year it is received. The principal is not currently paid to the beneficiary, so it is not taxed now; when it is eventually distributed, it is still excluded as life insurance proceeds. This is a common way to distinguish current taxable income from a future tax-free distribution of the original proceeds.
Why the other options are wrong
- A) There is no threshold test for the taxation of interest; the full amount of interest received in a year is ordinary income regardless of how it compares with the death benefit principal.
- C) Interest paid by the insurer is investment-type income and is not covered by the §101(a) exclusion, which protects only the death proceeds themselves, not their earnings. Such earnings are ordinary taxable income.
- D) Interest is taxed currently in the year it is received; it is not deferred until the principal is withdrawn, because the interest is actually paid out to the beneficiary.
Memory hook
Interest-only means interest is income — the principal sleeps tax-free until it pays.