73 / 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 a fixed period?

The “amount held by the insurer” is divided by the number of installment payments to be made in the fixed period. The quotient is the portion of each payment that is excludable from the beneficiary’s gross income as a return of principal. The balance of each guaranteed payment generally must be included in the beneficiary’s gross income. In addition to the prorated amount of principal, the surviving spouse of an insured who died before October 23, 1986, may exclude up to $1,000 of interest each year (guaranteed and excess).¹ If the primary beneficiary dies before the end of the fixed period, the secondary beneficiary may exclude the same amount of prorated principal from gross income, but all interest (guaranteed and excess) is includable.²

Example. Insured spouse died after October 22, 1986. Insured’s widow elects to receive $50,000 of proceeds in ten annual installments of $5,500 each. As a second payment, she receives $5,950 (guaranteed payment plus $450 excess interest). She may exclude $5,000 of the payment as a return of principal ($50,000 ÷ 10). Consequently, she must include in income the balance of the payment ($950).