California Life & Health Insurance Exam — All Questions

When a life insurance death benefit is paid to a named beneficiary as a lump sum, how is that benefit generally treated for federal income tax purposes?

• a.The entire amount is taxable as ordinary income
• b.The death benefit is generally received free of federal income tax✓
• c.Only the portion equal to premiums paid is tax-free
• d.It is taxed as a capital gain

Life insurance death proceeds paid to a beneficiary are generally received income-tax-free, one of the primary tax advantages of life insurance. It is therefore not taxed as ordinary income in full, nor limited to a return of premiums, nor treated as a capital gain. Note that if the death benefit is paid in installments, any interest earned on the retained proceeds is taxable, and the proceeds may still be part of the insured's estate for estate-tax purposes, but the core death benefit itself is income-tax-free.

In a nonqualified deferred annuity, how are withdrawals taxed during the accumulation phase under the standard tax rule?

• a.All withdrawals are entirely tax-free because the money was already taxed
• b.The principal (cost basis) comes out first and is taxable
• c.Earnings (interest) are considered withdrawn first and are taxable as ordinary income (LIFO)✓
• d.Withdrawals are taxed as long-term capital gains

For nonqualified annuities purchased after August 13, 1982, withdrawals follow last-in, first-out (LIFO) tax treatment: the taxable earnings (interest) are treated as coming out first and are taxed as ordinary income, and a 10% penalty may apply before age 59 1/2. The already-taxed principal (cost basis) comes out only after the earnings are exhausted, so the second option reverses the order. Annuity gains are ordinary income, not tax-free and not capital gains, which rules out the first and fourth options. During annuitization, the exclusion ratio instead spreads the return of basis across each payment.