What are the general tax implications of life insurance death benefits for beneficiaries?

• A. They are fully taxable as income
• B. They are generally received tax-free by beneficiaries
• C. They have a cap on the amount that is tax-free
• D. They incur penalties if not claimed within a year

Answer: (B)

Beneficiaries of life insurance policies typically receive death benefits tax-free. This means that when an insured individual passes away and the death benefit is paid out to the beneficiaries, they do not have to include that amount as income on their tax returns. This tax-free status is a key advantage of life insurance, as it allows the beneficiaries to receive the full benefit of the policy's value without any tax burdens.

This tax treatment promotes life insurance as an effective financial planning tool, helping to provide financial stability to loved ones after an individual's death. It ensures that the intended support is realized in its entirety, enabling beneficiaries to cover expenses such as mortgages, educational costs, and other financial obligations without the reduction that would occur if those funds were subject to income tax.

Other options do not accurately reflect the general treatment of life insurance death benefits. Benefits being fully taxable as income would discourage individuals from investing in life insurance for their loved ones, and having a cap on the tax-free amount does not align with IRS rules where typically the entire death benefit is excluded from taxable income. Additionally, suggesting that penalties apply for unclaimed benefits within a set timeframe introduces complications that are not representative of how life insurance policies function.