California Life and Health Insurance Practice Exam

How are death benefits typically treated for tax purposes?

1. Taxable as ordinary income

2. Exempt from federal income taxes

3. Subject to capital gains tax

4. Taxed at the state level only

The correct answer is: Exempt from federal income taxes

Death benefits from life insurance policies are generally exempt from federal income taxes. This means that the beneficiaries who receive the death benefit payout do not have to pay federal income taxes on the amount received. This tax treatment is designed to provide financial support to beneficiaries without the burden of additional taxation during what is likely an already difficult time. While there are some exceptions to this general rule—such as when the policy is part of the estate and may be subject to estate taxes—life insurance proceeds paid to beneficiaries directly are not considered taxable income. This unique treatment is one of the reasons individuals often purchase life insurance, as it ensures that their loved ones receive the full benefit of the policy without tax deductions. This exemption creates a favorable financial outcome for beneficiaries, allowing them to utilize the funds for expenses like mortgage payments, educational costs, or other financial obligations without worrying about federal tax implications.