71 / If excludable death proceeds are held by an insurer and are paid under a life income or installment option, how are the payments treated for income tax purposes?
The “amount held by the insurer” (usually the one-sum proceeds payable at the insured’s death) is prorated over the payment period. (If the settlement arrangement involves a life income with a guaranteed refund, or a guaranteed number of payments, the value of the guarantee must be subtracted from the one-sum proceeds before making the proration.) These prorated amounts determine the portion of each payment that may be treated as a return of principal. Consequently, the beneficiary may exclude this portion of each payment from gross income.1 All amounts received in excess of these prorated amounts are treated as interest, and are taxable as ordinary income to any beneficiary other than the surviving spouse of an insured who died before October 23, 1986. Such a surviving spouse is entitled to exclude up to $1,000 of such interest annually in addition to the prorated amount of principal.2
See Q 72 for a discussion of the treatment of a life income option, Q 73 for a discussion of the treatment of a fixed period option and Q 74 for a discussion of the treatment of death proceeds payable in installments based on a fixed amount.
1. IRC § 101(d)(1); Treas. Reg. § 1.101-4(a)(1)(i).