Unless an exception applies, life insurance proceeds are income taxable in which of the following circumstances?

• A. When the insured dies
• B. When ownership transfers while the insured is alive
• C. When the policy lapses
• D. When the beneficiary is the insured's spouse

Answer: (B)

Life insurance death benefits are generally excluded from the recipient’s gross income. The only exception that can make the proceeds taxable is when the policy’s ownership is transferred for valuable consideration while the insured is still alive, known as the transfer-for-value rule. In that case, the death benefit paid to the new owner can be included in gross income to the extent it equals the value received in the transfer (and any premiums paid after the transfer). So, among the options, an ownership transfer during the insured’s lifetime is the circumstance that can trigger income tax on the proceeds. The other scenarios do not create taxable income under the ordinary rules for life insurance proceeds.