South Carolina Life Insurance Practice Exam

If the beneficiary of a life insurance policy receives death benefit payments that consist of principal and interest, which portion will be taxed?

1. Only the principal

2. Only the interest

3. Both the principal and interest

4. Neither portion is taxed

The correct answer is: Only the interest

The correct answer is that only the interest portion of the death benefit payments is subject to taxation. Under the Internal Revenue Code, life insurance death benefits paid to beneficiaries are typically not taxable as income. This means that the principal amount received from the policy, which is essentially the face value of the insurance, is exempt from taxes. However, if the death benefit includes interest accrued over time, that interest portion is considered taxable income. The rationale behind this is that the principal represents a return of the beneficiary's investment (or the deceased's investment in the policy), while the interest earned is viewed as income generated from that investment. Therefore, beneficiaries should report any interest they receive as income when they file their tax returns. The distinction is essential for understanding tax implications related to life insurance proceeds, assuring that beneficiaries are compliant with tax regulations while benefiting from the financial support provided by the policy.