South Carolina Life Insurance Practice Exam

Is the death benefit of a life insurance policy taxed to the beneficiary if it is received as a lump sum?

1. Yes, it is fully taxed

2. No, it is not taxed

3. Only the interest portion is taxed

4. Only if the policy was a Modified Endowment Contract

The correct answer is: No, it is not taxed

The death benefit of a life insurance policy, when received as a lump sum by the beneficiary, is generally not subject to federal income tax. This means that the entire amount that the beneficiary receives is typically tax-free. The rationale behind this is tied to the underlying principle of life insurance, which is designed to provide financial protection for beneficiaries upon the death of the insured. In the case of a lump sum payment, the IRS treats the death benefit as a tax-free event, allowing beneficiaries to receive the funds without the burden of income tax. This tax advantage is one of the main selling points of life insurance policies, as it provides peace of mind not only in terms of coverage but also in the financial implications for loved ones. When considering other options, only the interest portion earned on the death benefit, if paid in installments or if it is held in an interest-bearing account, could be taxable. Modified Endowment Contracts, or MECs, have different tax implications primarily affecting policy loans and withdrawals, rather than the death benefit itself received in a lump sum. Thus, understanding that the primary death benefit remains untaxed reinforces why the choice stating that it is not taxed is the accurate response.