What is true regarding the tax implications of death benefits in life insurance?

When it comes to the tax implications of death benefits in life insurance, it is accurate to say that death benefits are generally not subject to federal income tax for the beneficiary. This means the beneficiary receives the full amount of the death benefit without having to pay income taxes on it. However, any interest that is earned on the death benefit after the insured's passing is taxable. This interest accrues during the time the insurance company holds the funds before they are disbursed to the beneficiary or if the death benefit is paid out in installments over time.

The rationale behind this tax treatment is rooted in the intent of life insurance as a financial tool meant to provide financial support to beneficiaries without burdening them with an immediate tax obligation on the death benefit itself. The tax-exempt nature of the benefit ensures that the policy serves its purpose effectively, allowing beneficiaries to use the funds as needed to cover expenses resulting from the death.

This is why the choice indicating that death benefits are not taxable, but interest earned is, accurately reflects the tax implications of life insurance death benefits.