West Virginia State Life Insurance Practice Exam

Which of the following statements is CORRECT regarding the tax treatment of a lump-sum payment paid to a life insurance policy's primary beneficiary?

1. All proceeds are taxable in the year they are received

2. Proceeds are taxed only if withdrawn within the first year

3. All proceeds are income tax-free

4. Proceeds are taxed on a sliding scale

The correct answer is: All proceeds are taxable in the year they are received

The correct statement regarding the tax treatment of a lump-sum payment paid to a life insurance policy's primary beneficiary is that all proceeds are income tax-free. When a life insurance policy pays out benefits to a named beneficiary following the death of the insured, the payout is not included in the beneficiary's taxable income. This means that the beneficiary receives the full amount of the death benefit without any income tax liabilities attached to it. This tax treatment is one of the primary advantages of life insurance, as it provides a financial benefit to the beneficiaries that is not diminished by taxation. While choices related to taxation may present scenarios where proceeds could be taxable, such as withdrawals or varying rates, they do not apply to the straightforward case of a lump-sum death benefit payout under a life insurance policy. Therefore, understanding the tax implications helps beneficiaries plan for their financial management and ensures they utilize the benefits as intended without the burden of tax liabilities.