Life insurance death proceeds are generally income tax free to the beneficiary, except in which situation?

• A. When a loan against the policy is outstanding
• B. When a transfer of ownership has taken place
• C. When the beneficiary is a spouse
• D. When the policy lapses

Answer: (B)

Life insurance death benefits are normally received income-tax free by the beneficiary under the tax rules for life insurance proceeds. An important exception is the transfer-for-value rule: if ownership of the policy is transferred for valuable consideration, the death benefit may become taxable to the recipient. In that situation, the amount of the death benefit can be included in the recipient’s gross income to the extent the policy was transferred for value (often tied to the value or premiums paid). That’s why the situation where ownership has been transferred for value is the one that removes the usual tax-free treatment. The other scenarios don’t create this taxability: an outstanding loan reduces the death benefit but doesn’t by itself make the proceeds taxable, a spousal designation isn’t a tax exception, and a lapse leaves no death benefit to tax.