How are life insurance proceeds taxed to beneficiaries?

• A. Death benefits are generally income-tax-free to beneficiaries; taxes may apply if the policy is owned by the decedent or included in their estate.
• B. Death benefits are always taxed as ordinary income.
• C. Death benefits are taxed only if paid to a non-relative.
• D. Death benefits are never taxed regardless of ownership.

Answer: (C)

Life insurance death benefits are generally income-tax-free to beneficiaries. The taxes that can apply come from ownership and estate considerations. If the policy is owned by the insured at death or if the proceeds are included in the insured’s gross estate, the death benefits can be subject to federal estate tax. There’s also the 3-year rule: if the policy was transferred for valuable consideration within three years of death, the proceeds may be included in the insured’s estate for estate tax purposes. So the usual tax treatment is income-tax-free for the beneficiary, with potential estate tax issues if ownership sits with the decedent or if the policy is tied to the decedent’s estate. The other options don’t fit because the benefit is not normally taxed as ordinary income, and relationship to the beneficiary isn’t the sole determinant.