Connecticut Life Producer Practice exam

How are life insurance death proceeds taxed if taken as a lump sum?

1. Completely taxable as income

2. Tax-free

3. Only the interest is taxable

4. Subject to state tax only

The correct answer is: Tax-free

When life insurance death proceeds are taken as a lump sum, they are received by the beneficiary tax-free. This means that the full amount of the proceeds is available to the beneficiary without being subject to federal income tax. The rationale behind this tax treatment is rooted in the purpose of life insurance, which is to provide financial support to loved ones after the policyholder's death. Moreover, death benefits are considered to be a form of financial compensation for the loss of life, rather than income earned. This aligns with the tax code's provisions, which recognize that life insurance benefits should be exempt from income tax, thereby providing a financial safety net for the beneficiaries. Although there are circumstances under which interest earned on the proceeds may become taxable if the payout is not taken as a lump sum, the core benefit of the original death benefit itself remains tax-free. This tax advantage highlights why many individuals consider life insurance an important financial planning tool.