How is the interest earned on life insurance policy proceeds treated for tax purposes?

When it comes to the interest earned on life insurance policy proceeds, the tax treatment is specific to the type of proceeds involved. The correct understanding is that the interest earned on the death benefit of a life insurance policy is taxable to the beneficiary. This means that while the death benefit itself is generally tax-exempt, any interest that accrues on that benefit after the insured's death is subject to taxation.

For example, if an insurance payout is delayed and earns interest during that time, or if the proceeds are left to accumulate interest in an insurance company's account, the beneficiary must report and pay tax on any interest earned. This aligns with general tax principles that state income earned from investment or monetary assets is taxable unless specifically exempted.

In contrast, the death benefit itself is tax-exempt, which is why that aspect might sometimes lead to confusion regarding the treatment of the interest earned. This is why the correct answer highlights the taxability of interest specifically, while excluding the overall benefit from taxation.