Tennessee Insurance Practice Exam

Which of these statements is INCORRECT regarding the federal income tax treatment of life insurance?

1. Entire cash surrender value is taxable

2. The death benefit is taxed as income

3. Premiums paid are not tax-deductible

4. The policyholder can borrow against the cash value tax-free

The correct answer is: The death benefit is taxed as income

When considering the federal income tax treatment of life insurance, it is important to understand how various components are taxed. The statement claiming that the death benefit is taxed as income is indeed incorrect. In reality, the death benefit paid out to beneficiaries of a life insurance policy is generally not subject to income tax. This tax treatment is a key benefit of life insurance, intended to provide financial support to beneficiaries without the burden of a tax liability. Therefore, beneficiaries receive the full amount of the death benefit, and it does not contribute to their taxable income. The other statements reflect accurate aspects of life insurance tax treatment: the entire cash surrender value can indeed be taxable when the policy is surrendered for cash, premiums paid for life insurance are not tax-deductible for personal life insurance policies, and the policyholder can borrow against the cash value without immediate tax consequences, as long as the policy remains in force. Overall, the tax implications of life insurance are structured in a way that provides significant advantages for policyholders and their beneficiaries.