South Carolina Life Insurance Practice Exam

Which circumstance could result in life insurance proceeds being taxable as income?

1. When the insured has a new beneficiary

2. When there is an incident of ownership at death

3. When the policy has been in effect for less than two years

4. When the death benefit exceeds $1 million

The correct answer is: When there is an incident of ownership at death

A life insurance policy is typically not subject to income tax for beneficiaries when the insured passes away. However, there are specific circumstances that can lead to the life insurance proceeds becoming taxable. One significant circumstance is when there is an incident of ownership at the time of the insured's death. Incident of ownership refers to the ability of the policyholder to exercise control over the policy, such as the power to change beneficiaries or to take loans against the policy. If the insured retains such control at the time of death, the cash value of the policy may be included in the insured’s estate for tax purposes. This inclusion could result in the proceeds being subject to federal estate taxes if the total value exceeds the applicable exemption limit. Hence, in cases where the incident of ownership is present, the life insurance proceeds may be taxable as income due to their inclusion in the owner's estate. In contrast, simply naming a new beneficiary, the duration of the policy, or the amount of the death benefit do not, in themselves, result in such tax implications. The critical aspect here is the control exercised over the policy, which directly influences tax treatment upon death.