What tax treatment applies to life insurance policy proceeds?

Life insurance policy proceeds generally receive favorable tax treatment for beneficiaries. Under federal tax law, the face amount of the life insurance benefit paid to beneficiaries is typically not subject to income tax and, therefore, is generally considered non-taxable. This means that beneficiaries receive the benefits without owing federal income taxes on the amount they receive.

However, the exception to this non-taxable treatment involves interest earned on the proceeds if the payment is delayed. If the insurance company retains the proceeds and pays interest to the beneficiary, that interest income is taxable. Therefore, the standard treatment for the death benefit itself is non-taxable, while any interest accrued during the waiting period before the payout becomes taxable income. This nuance makes the chosen answer accurate in reflecting the typical tax treatment of life insurance proceeds.

Additionally, while life insurance payouts can be subject to estate taxes if the insured’s estate exceeds certain thresholds, that aspect doesn't affect the income tax status of the proceeds, hence ruling out the choices regarding taxation as ordinary income or treating them solely as subject to estate taxes.