72 / 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 if the installments are payable based on the life of the beneficiary?

If the installments are payable for the lifetime of the beneficiary (a life income option), the “amount held by the insurer” is divided by the beneficiary’s life expectancy to determine the amount that may be excluded from gross income each year as a return of principal. In the case of amounts paid with respect to deaths occurring after October 22, 1986, the beneficiary’s life expectancy must be determined using IRS annuity tables V and VI.¹ In the case of amounts paid with respect to deaths occurring before October 23, 1986, the beneficiary’s life expectancy is taken from the mortality table that the insurer uses in determining the amount of the installments (not from the IRS annuity tables).² If there is a refund or period-certain guarantee, the amount held by the insurer must be reduced by the present value of the guarantee before prorating for the exclusion.³ The present value of the guarantee is determined by using the insurer’s interest rate and the applicable mortality table. The excludable amount, once determined, remains the same even though the beneficiary outlives his or her life expectancy. The balance of the payments is taxable income to any beneficiary other than the surviving spouse of an insured who died before October 23, 1986. The spouse of such an insured may exclude up to $1,000 of interest each year in addition to excluding the prorated amount of principal. If the beneficiary dies before receiving all guaranteed amounts, the secondary beneficiary receives the balance of the guaranteed refund, or guaranteed payments, tax-free.⁴ Excess interest allowed by the company in addition to the guaranteed refund would be taxable income to the secondary beneficiary, however.⁵

Example. Insured husband died after October 22, 1986. Insured’s widow elects to receive $75,000 of death proceeds under a refund life income option. The company guarantees her payments of $4,000 a year. According to Table V and the interest rate used by the insurer, her life expectancy is 25 years and the present value of the refund guarantee is $13,500. The $75,000 must first be reduced by the value of the refund guarantee ($75,000 – $13,500 = $61,500). This reduced amount, $61,500, is then divided by her life expectancy to find the amount that she may exclude from gross income each year as return of principal. This amount is $2,460 ($61,500 ÷ 25). Her taxable income from the guaranteed payment is $1,540 a year ($4,000 – $2,460). If the widow dies before receiving the full $75,000, the balance of the guaranteed amount will be received tax-free by the secondary beneficiary.

If a joint-and-survivor option is elected, the “amount held by the insurer” is divided by the life expectancy of the beneficiaries as a group to determine the annual exclusion of principal. The same amount of principal is excludable during the joint lives and the lifetime of the survivor.⁶

1. IRC § 101(d)(2)(B)(ii); Treas. Reg. § 1.101-7.

2. Treas. Reg. § 1.101-4(c).