74 / 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 amount?

The “amount held by the insurer” is divided by the number of payments required to exhaust principal and guaranteed interest. 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.¹ The surviving spouse of an insured who died before October 23, 1986, may exclude up to $1,000 of interest each year in addition to the prorated amount of principal. Payments extending beyond the guaranteed period (payments comprised entirely of excess interest) are fully taxable. (There is a difference of opinion as to whether the surviving spouse’s $1,000 annual interest exclusion, even if otherwise available, can be applied to these additional excess interest payments.) If the primary beneficiary dies before the end of the guaranteed payment period, the secondary beneficiary may exclude the same amount of prorated principal from gross income.

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1. Treas. Reg. § 1.101-4(g), Ex. 2.